Originally published on Forbes.com.
The Tax Court’s decision in the case of Victor and Daniela Kantchev did not really break any new ground in the hobby loss analysis of his photography business. If anything the Court took some ground that taxpayers had won from the IRS back. There was another aspect to the case that was even more interesting. Mr. Kantchev lost money not only as a photographer, but also as a filmmaker and the filmmaker losses were denied on other grounds perhaps providing another illustration of Relly’s Fourth Law of Tax Planning –Execution isn’t everything, but it’s a lot.
Lovely Pictures – But No Deductions
The stakes were not that high – less than $20,000 in tax and penalty for the years 2008, 2009, and 2010. Over the three years. the family’s positive income came mostly from Mrs. Kantchev’s salary as a registered nurse. Over the three years, there were net losses from the photography business of about $25,000. There was no gross photography income in 2008 and 2009 and just over $3,000 in 2010.
Mr. Kantchev took photographs with a nondigital camera. The negatives he created were scanned to created digital images that he altered using software. The resulting images were printed onto paper, canvas, and metal. He was inspired by Ansel Adams and took scenic photos of the American West. I found an album online identified as The American West by Victor Kantchev. The images are very striking. My covivant, who likes that sort of thing even more than I do, was very impressed. Too bad CV is not a Tax Court judge.
Judge Chiechi ran through the standard nine-factor drill:
(1) the manner in which the taxpayer carried on the activity, (2) the expertise of the taxpayer or his advisors, (3) the time and effort expended by the taxpayer in carrying on the activity, (4) the expectation that assets used in the activity may appreciate in value, (5) the success of the taxpayer in carrying on other similar or dissimilar activities, (6) the taxpayer’s history of income or loss with respect to the activity, (7) the amount of occasional profit, if any, which is earned, (8) the financial status of the taxpayer, and (9) the extent to which elements of personal pleasure or recreation are involved.
Mr. Kantchev pretty well struck out on all of them. Compounding his problem, Judge Chiechi did not find his testimony or that of his son or his accountant at all convincing, Mr. Kantchev’s testimony was in material respects found to be “uncorroborated, general, self-serving, vague, and conclusory”. The judge was not any kinder with regard to the testimony of accountant Ivan Soilov nor son Alexander who while pursuing an MBA in finance was helping his father with marketing.
Mr. Kantchev indicated that 2008 and 2009 were really bad years in the art market in general and that his business actually became profitable in 2011 and thereafter. That might have helped if the judge had believed him, but he did not have any evidence. He also did not keep separate books and records for his photography activity. What is troubling about the decision is the judge’s dinging him for not having a written business plan nor consulting with experts. The Tax Court seemed to be moving away from this attitude when it came to artistic activities which are inherently speculative. At least that was the holding in the Crile decision. It may well be that the judge was kind of piling on.
And The Film
One of the things that hurt Mr. Kantchev in claiming his photography losses was that during that period he had been devoting most of his energy to producing a film. That was through his S corporation, Victory Film Productions. The film, “Fire Lily” won several festival awards. Although, frankly, I don’t think I have ever heard of an independent film that did not have some sort of claim to be “award-winning”.
I managed to find a trailer for Fire Lily. The screenwriter Dr. Kenneth Stilson of SoutheastMissouri State University, in an interview, described the film this way.
“’Fire Lily’ is the tale of a sparkling person trapped in a putrid existence,” he said. “It’s partly inspired by Henrik Ibsen’s great 19th-century drama, ‘A Doll’s House.’ It is a ‘coming-of-age’ film about the maturation of a 22-year-old girl living in a small Midwestern town who emerges from the drama of love, sex and relationships.
Regardless, the S Corp had passed through nearly $100,000 in loss to Mr. Kantchev in 2007, most of which was carried forward into 2008 along with another nearly $10,000 loss. The IRS did not attack the losses with Section 183 (hobby loss). They had a more subtle trap. Generally, when you make a film you are supposed to capitalize your costs and recover them through depreciation deductions.
Now it happened that until this year producers could elect to deduct production costs. There are limits and qualifications, but it is pretty clear that “Tiger Lily” met those and that Victory could have elected to expense the costs. Only the corporation didn’t. Mr. Kantchev argued that the corporation effectively made the election by deducting the costs. It is worth noting that there are some elections that you make that way. The election under Section 181 – Treatment of certain qualified film and television productions – just does not happen to be one of them.
Another Angle
I became so fascinated with Fire Lily that I just had to go the extra mile. I reached out to both the producer and the screenwriter. I did not hear from Mr. Kantchev, but I did hear from Professor Stilson
Fire Lily was a labor of love for me. I am the writer and director of this film. It was based on my play, Where the Lilies Grow, which I wrote after the death of my grandfather.
Victor Kantchev approached me after seeing and reading my play and asked if I would be interested in turning it into a screenplay. I agreed to do this, as well as direct the film. It was a legitimate project, and the film was an invited entry into two film festivals, and it won best feature film at the American Artist Film Festival. We all had high hopes for it to be picked up by a distributor and marketed—none of which materialized.
My contract was based entirely on the contingency on Mr. Kantchev selling the film to a distributor, and I would receive a percentage. However, he was very secretive about any and all things financial. I asked many times, but he never revealed anything about the film’s production budget. I have never received any payment for my work on Fire Lily; in fact, it cost me quite a bit of my own money, as well as 18 months of my time. If it was sold, I would certainly like to know so that I could seek compensation. I believe many of the actors involved in this project had agreements with Mr. Kantchev where the final part of their contracts would not be executed until the film sold. To my knowledge, these actors received payment during production, but they never received final payment.
I was vaguely aware of Mr. Kantchev trouble with taxes, as he asked me to write a statement for him to submit as part of his defense. I agreed to do this, but I only confirmed the film was a legitimate and finished project from my perspective. Other than that, I stated that I had no knowledge of any financial matters associated with Fire Lily.
Here is hoping that the satisfaction of having his work preserved on film is a consolation to the professor, but that’s not what is interesting about this to a tax geek. Mr. Kantchev illustrated my fourth law by failing to attach an election to the corporate return, but that failure did not turn the costs into nondeductible forever, as a hobby loss finding would. They are recovered through depreciation.
Arguably “Tiger Lily” was “placed in service” when it was shown at festivals. Depreciation on films can be done by using the “income forecast” method. Typically the income from a film is bunched in the early years. So if you expect half the revenue in year one, you deduct half the cost in that year. It would seem that by 2010 a reasonable forecast might have been zero (at least that is how it looks in retrospect). Maybe that argument is a stretch, but I’m surprised that it was not raised.
At any rate, this seems to be the first litigation ever to address the Section 181 election . Makes me glad that I was paying attention when I ran into it.