Originally Published on forbes.com on January 16th, 2012
______________________________________
If you want to reduce your federal income tax, the most effective means is to post a large negative number somewhere on the schedules that feed into the income section of Form 1040. Lowering that ”total income” amount on line 22 is generally the most direct route to tax savings. The stuff that comes after that to compute your taxable income or provide credits against the tax tends to be hedged by a variety of limitations and thresholds. There are very peculiar circumstances, where this is not true.
I explained in this piece how Warren Buffet might have been able to save $675,000 by increasing his gross income. On the opposite end of the income spectrum, abusive preparers are sometimes able to increase refunds by manufacturing income, because of the peculiarities of the earned income credit. Those exceptional circumstances illustrate the principle that a good tax plan should always involve running complete scenarios rather than relying on rules of thumb. Nonetheless, for the vast majority pulling down your “total income” number on line 22 is the most direct tax reduction strategy.
It is not that surprising, then, that much of the complication in tax stems from rules designed to make it difficult to get negative numbers into your total income computation. I think I did a pretty good overview of the obstacles to negative numbers in a post titled Through the Hoops. There are five sets of rules that you need to satisfy. A lot of planning errors result from mixing the rules up. The very first hoop, which is what I am writing about in this piece is Code Section 183, which limits deductions for activities “not entered into for profit” to the income from such activities. Losses from such activities are sometimes referred to as “hobby losses”, but the concept is broader. 183 cases are something I watch for. You might say they are a hobby of mine. I noted two recently.
Around the World While on Sabbatical – Michael S. Oros v. Commissioner, TC Memo 2012-4
Michael Oros was a full-time employee of Intel. He figured out a great way to spend his vacation and paid sabbatical:
Before 2006 petitioner had no experience writing or publishing books. In 2006 petitioner completed a business plan to write and self-publish a book about his upcoming worldwide trip and the planning and execution of such a trip. Petitioner, although not professionally trained, is an experienced photographer and intended to use the photographs he took during his trip as a focal point of his book. Petitioner’s Trip On November 20, 2006, petitioner began a 4-month trip during which he visited South America, Asia, Africa, and Australia. During 2006 petitioner traveled exclusively throughout South America. During 2007 he traveled to Asia, Africa, and Australia. Throughout the entire trip petitioner was on either a paid vacation or a paid sabbatical from Intel.
Mr. Oros took a lot of pictures and kept meticulous records of them. When it came to sitting down and writing the book, though, he did not get very far:
While in South America he took 4,542 photographs of businesses, temples, monuments, natural wonders, and wildlife. Petitioner maintained a contemporaneous journal in which he wrote about his different experiences. Petitioner’s Travel Book As of March 2011 petitioner had not published or completed a book about his worldwide trip. Petitioner had written an “early draft” of the book consisting of approximately 100 to 150 pages. Petitioner did not produce a draft or outline of the book at trial.
The Court found that he had just not done enough to raise the activity to the level of a trade or business:
Specifically, writing can qualify as a trade or business even if it is not the sole activity of the taxpayer. However, “there must be some conscientious intent and effort to engage in and continue in the writing field for the purpose of producing income and a livelihood in order to have writing qualify as a trade or business within the meaning of section 162(a) of the Code.
The Court also had issues with substantiation. Although he had receipts for his expenses, they were not correlated with the business purposes of the expenditures. Mr. Oros was representing himself in Tax Court, which is understandable given the relatively low stakes. I’m wondering if the case might have gone the other way if he had had a tax litigator in his corner. He had consulted with a CPA on the deductibility of his expenses before filing, which at least saved him penalties. Lew Taishoff did a nice piece on this case titled “I Could Write a Book.”
As an aspiring writer myself, I have to say I can understand writing without making money or even making just a little money, but I am way too cheap to lose money at it.
….And I Was Going to Learn How to Fly – Robert L. Hand, et al. v. Commissioner, TC Summary Opinion 2012-1
Robert Hand was facing a more substantial notice of deficiency, over $45,000 including the accuracy penalty. Mr. Hand was a financial adviser and commercial real estate broker. He began chartering planes to scout out property, taking aerial photographs. I imagine if you spend enough time in small planes taking pictures, you are going to get a strong itch to be at the controls. That may account for Mr. Hand’s next step:
In late 2007, petitioner began taking flight lessons so that he could obtain a private pilot’s license and pilot his own plane. In December of 2007, petitioner purchased a Cessna 172S aircraft. Petitioners filed a joint Federal income tax return for 2007 and deducted the cost of the flight lessons as a business expense on their Schedule C, Profit or Loss From Business.
Strictly speaking this is not a hobby loss case. Mr. Hand tried to associate his flying lessons with his commercial real estate activities. The Court was not buying it:
We are not convinced, however, that the flight lessons petitioner received maintained or improved the skills required to be a commercial realtor. Sec. 1.162-5(a)(1), Income Tax Regs. Petitioner is skilled at finding properties and creating marketing brochures for prospective buyers. A disconnect exists, however, between these skills and the flight lessons taken by petitioner. Admittedly, evaluating properties from the air and placing aerial photographs in marketing brochures may be helpful to petitioner’s business. However, in 2005, 2006, and 2007, petitioner was able to evaluate properties and acquire aerial photographs without piloting a plane. Petitioner presented no evidence to explain why flying lessons were now required in order for him to view properties or obtain aerial photographs. Although the correlation need not be precise, petitioner has failed to persuade us that a direct or proximate relationship exists between the flight lessons he received and the skills required to be a commercial realtor.
Mr. Hand also had substantiation problems. The Court upheld the 20% in his case.
Here are a few other hobby loss posts:
Here are a few other hobby loss posts:
You can follow me on twitter @peterreillycpa.
Trackbacks/Pingbacks