Originally published on Forbes.com.
There is a subtle irony in the yacht chartering hobby loss decision from the Tax Court in the case of Charles and Rhoda Steiner. Judge Ruwe seems to argue that not being aggressive in taking deductions might be held against you. That would make for an exception to Reilly’s Eleventh Law Of Tax Planning – Pigs get fed. Hogs get slaughtered. The case is also a counterexample to my view that hobby loss people usually come out ahead even when they lose. Or maybe it is not.
Quite A Lady
According to the decision, Mr. Steiner was a CPA who really made good. He bought an electrical supply company and built it so that it had over 1,000 employees and several hundred million dollars in revenue. He acquired some other companies too, but this case is about what he did with his lucre rather than how he garnered it. Personal income was over $5,000,000 in 2011 and $10,000,000 in 2012. So he could afford a yacht.
And it was quite a yacht. The Triumphant Lady was purchased in 2001 for $4,950,000. In 2006 a refit was started which ended up costing $10,839,000 by the time it was finished in 2009. The Lady had a full-time crew under the command of Captain Bryan Pridgeon. It was used personally by the Steiners until 2009.
Starting In Business
In 2009, the Steiners were approached about chartering the yacht. They engaged International Yacht Collection as exclusive agent and chartered the yacht for one week in May 2009. Well that was easy. So as personal issues influenced the Steiners to list the Lady for sale, they decided to make a business of the chartering effort.
Losses for 2011 and 2012 were $705,406 and $122,420. There was only one one-week charter during the whole period for a measly $150,000. Nonetheless, the crew had to be kept on to maintain seaworthiness. The yacht was sold early in 2012, for $4,450,000. There is no discussion of there being a 1231 loss, which would have been a doozy. If that got by, then the Steiners were big winners (Well taxwise anyway).
Code Section 183 denies deductions for activities not entered into for profit. This is a matter of the taxpayer’s intent, which makes it kind of metaphysical. The IRS finds itself in the position of a Calvinist trying to discern whether the fellow in the next pew is really a member of the elect .
The Regulations
The regulations have outlined nine factors to be considered. It is not a really elegant system. The first factor is divided into three subfactors. The sixth and seventh factors seem kind of redundant. Also the sixth, seventh and eighth factors will almost inevitably lean toward the IRS in a case that gets litigated.
(1) Manner in which the taxpayer carries on the activity.
(a) business-like manner including accurate books and records
(b) manner similar to other activities of the same nature which are profitable
(c) change operating methods, adopt new techniques, abandon unprofitable methods
(2) The expertise of the taxpayer or his advisors
(3) The time and effort expended by the taxpayer in carrying on the activity
(4) Expectation that assets used in 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 losses with respect to the activity
(7) The amount of occasional profits, if any, which are earned.
(8) The financial status of the taxpayer.
(9) Elements of personal pleasure or recreation
Be Aggressive?
On the first factor there was kind of mixed bag. There was a business account, but a lot of stuff ran through personal accounts. There was no formal business plan – something which the Tax Court has been inconsistent about. Then there is this really odd observation
Finally, petitioners’ tax reporting was not businesslike. Petitioners dispute this. They contend that they did not deduct $635,363 of depreciation for 2011 that their accountants advised they were entitled to because there would be recapture upon sale. However, for 2010 petitioners deducted only $30 of charter-related expenses although the activity incurred significant expenses.
By the time the 2011 return was due, they already knew the yacht had been sold. Not claiming the depreciation deduction kept the loss for 2011 below a million. On the other hand, at least in principle, basis is reduced by depreciation allowed or allowable. The elephant in the room on these returns would seem to be the possible 1231 loss in 2012.
Regardless, it is ironic that a factor in denying all deductions is that the taxpayer did not claim some deductions.
One other note for any of my readers who are good at this stuff. For the life of me, I have not been able to reverse engineer that depreciation number.
Other Factors
In studying 183 cases, my anecdotal observation is that it seems that the first factor is really what determines the case. Any ambiguity in the other factors gets pushed in the same direction. The only win for the taxpayer was the ninth factor – “Elements of personal pleasure”. It is really not a lot of fun to pay for a yacht that you are not using. There is an old joke about a boat being a hole in the water into which you pour money. That was Triumphant Lady in 2011 and 2012.
Did They Actually Win?
As I have been studying 183 cases, I have been finding myself thinking that practitioners might want to be more aggressive in this area. Start with the assumption that your client is going to do what it is they want to do regardless. Say it’s breeding mutant turtles. And they honestly think there is a way that they can make money at it, even if it is a long shot.
A not improbable outcome is that they will rack up losses for six or seven years and then get challenged for years eight and nine. Even if they lose, they have still won compared to listening to some stick in the mud telling them not to take the losses in year one.
Of course, that is not what happened with the Steiners. They got challenged right out of the box, but there is really something a little odd. Their basis in Triumphant Lady was around $15 million and they put her for sale at just under $16 million staking out the position that she was worth roughly basis when the leasing operation started. She was ultimately sold for $4,455,000 in 2012.
A loss on a personal use asset is not deductible. The basis for loss on a personal use asset converted to business use is the lesser of cost basis or fair market value at the point of conversion. What loss, if any, was claimed by the Steiners on the 2012 sale?
If all that was going on here was tax planning, converting that loss to business would have been the main point of the exercise since the decision to put the yacht up for sale and to start chartering happened around the same time.
There is nothing about any sort of loss adjustment, so maybe the Steiners effectively did win.
Other Coverage
Amy Lee Rosen has something on the case behind the Law360 paywall.
Ken Berry had Taxpayers Lose in Air and on Sea in Hobby Loss Cases on Accountingweb. That article also covered the Kurdziel case.