As professionals, we've been beaten over the head with the Sec. 183 hobby loss rules, which prohibit deductions for activities not engaged in with the intent of making a profit. Some practitioners think, and with good reason, that to avoid the hobby loss rules, a company has to show a profit after three years, but that's more a rule of thumb. For example, let's say a client is aggressively attempting to realize income from the activity and after year 3, he or she is still not turning a profit. Does this mean that the client must ignore a loss in year 4 of the activity? To answer this question, let's examine two U.S. Tax Court cases addressing profit motive that have recently been decided, in which the court looked more at other factors than how many years of losses occurred before ruling against the taxpayers.
The first case is Hylton, T.C. Memo. 2016-234. Cecilia Hylton is the president of the Hylton Group, a successful real estate group founded by her father. Hylton Group's business is primarily developing real property, building and selling residences and apartment buildings, and managing commercial and residential properties in Virginia.
In 1998, Hylton started Hylton Quarter Horses (HQH), the main business of which is breeding, training, showing, and selling quarter horses. The predominant use for quarter horses is recreational riding, but they are also used in rodeos and horse shows and as working ranch horses.
In operating HQH, Hylton sought to raise the best quarter horses possible by adopting the following practices: getting the best mares; acquiring stallions to breed; breeding the mares; producing foals; and culling some of the foals and training the remainder. Hylton did not prepare a formal business plan when she started HQH, but the record includes an undated five-page written "business plan" that included a single-page income and expense projection and was prepared by her CPA in response to an IRS audit.
Sometime after 2005, Hylton moved some of HQH's breeding horses from Virginia to Texas, because it is "the premier show place" of quarter horses and the location of many breeding experts. She kept mares, colts, and her three stallions in Texas and contracted with three entities there. She usually traveled to Texas once a year for approximately one week.
During the years in issue, Hylton maintained a separate mailing address for HQH and a separate checking account, which was used to pay most of HQH's horse-related expenses—feed, trainers, veterinarians, and blacksmiths. She maintained a separate brokerage account for HQH, which was used to pay show fees, camping fees, and other horse-show-related expenses.
Hylton and her horse activity team would typically meet "once a month, sometimes more" to review HQH's invoices and receipts. No minutes or records were kept of these meetings. HQH's invoices and receipts were kept in files at Interstate Investment and would be provided to Hylton's tax return preparer to prepare returns.
For each of the years 2004 through 2011 HQH's expenses far exceeded its income, with almost $2 million in losses being incurred in two of those years.
The IRS determined that Hylton's ownership and operation of HQH was an activity "not engaged in for profit" under Sec. 183 and disallowed loss deductions claimed on her Schedules F, Profit or Loss From Farming, for those years. A taxpayer may not fully deduct expenses from an activity under Sec. 162 or 212 if the activity is not engaged in for profit (Sec. 183(a)). If an activity is not engaged in for profit, no deduction is allowed except to the extent provided by Sec. 183(b), which allows deductions only to the extent of gross income from the activity. Sec. 183(c) defines an activity not engaged in for profit as "any activity other than one with respect to which deductions are allowable for the taxable year under section 162 or under paragraph (1) or (2) of section 212."
Deductions are allowed under Sec. 162 for the ordinary and necessary expenses of carrying on an activity that constitutes the taxpayer's trade or business. Deductions are allowed under Sec. 212 for expenses paid or incurred in connection with an activity engaged in for the production or collection of income or for the management, conservation, or maintenance of property held for the production of income. Both Code sections require a profit motive, which is interpreted similarly as requiring profit to be a primary purpose (see Groetzinger, 480 U.S. 23 (1987), in which the Court held that a gambler had a primary purpose of making a profit and could therefore deduct his losses).
Under Sec. 183(d), an activity that consists in major part of the breeding, training, showing, or racing of horses is presumed to be engaged in for profit if the activity produces gross income in excess of the deductions for any two of seven consecutive years. Because HQH did not produce income in excess of its deductions at any time, the presumption does not apply.
Regs. Sec. 1.183-2(b) provides a nonexhaustive list of the nine factors to determine whether an activity is engaged in for profit:
- Whether the taxpayer carries on the activity in a businesslike manner;
- The expertise of the taxpayer or his or her advisers;
- The time and effort expended by the taxpayer in carrying on the activity;
- The expectation that the assets used in the activity may appreciate in value;
- The success of the taxpayer in carrying on similar or dissimilar activities;
- The taxpayer's history of income or losses for the activity;
- The amount of occasional profits, if any, which are earned;
- The taxpayer's financial status; and
- Elements of personal pleasure or recreation.
All facts and circumstances are to be taken into account, and no single factor is determinative. The court examined each of these factors in turn and determined that Hylton did not participate in the quarter horse activity with a profit motive as her primary or dominant objective.
In Moyer, T.C. Memo. 2016-236, the facts are a little different, but the same principle applies. Calvin Moyer was educated as a chemist. In 1968, he joined DuPont's human relations department, where he trained DuPont employees in a variety of human relations topics.
Moyer took early retirement from DuPont in January of 1992 at age 50. Sometime after he retired, but before 2004, both Moyer and his wife began receiving DuPont pensions and Social Security benefits.
In 1992, DuPont outsourced much of its human relations training. Moyer and four other retired DuPont employees started a business to provide DuPont with human relations training services as outside contractors similar to those they had provided at DuPont. In 1994, after disagreeing on business strategy, the group agreed to cease doing business.
In 1994, Moyer and another person formed Strategic Learning Systems Inc. (SLS), an S corporation, which provided human relations training, including in-class human relations training on a variety of topics, and created several marketing brochures. These trainings were one-day workshops with DuPont—SLS's only client. DuPont constituted at least 80% to 90% of SLS's total business. In 1996, Moyer's partner left SLS, and Moyer ran it himself.
In 2005, SLS lost DuPont as a client and after 2006 it did not have any other clients. SLS had no gross receipts for 2010 through 2015.
SLS never kept books or records or maintained a budget. Moyer did not use books or records to evaluate the business's financial performance, nor did he file a timely tax return for SLS for the 2004, 2005, 2006, 2007, or 2008 tax years. In 2014, SLS filed delinquent Forms 1120S, U.S. Income Tax Return for an S Corporation, for those years in connection with previous Tax Court cases after the IRS had issued notices of deficiency to him (as SLS's shareholder) or to his wife (because she signed their joint return). Moyer acknowledged in his testimony that the preparation of the Forms 1120S in 2014 was the first time he ever determined SLS's annual expenses for tax or any other purpose.
Neither Moyer, his wife, nor SLS timely filed a federal income tax return for the 2009 tax year.
In 2012, the IRS mailed Mrs. Moyer a substitute for return and a notice of deficiency for 2009 using the married-filing-separately filing status and determining a deficiency of $9,006 along with penalties under Secs. 6651(a)(1), 6651(a)(2), and 6654(a).
On Oct. 20, 2014, the taxpayers submitted a joint federal income tax return for 2009, which itemized deductions on Schedule A, Itemized Deductions. Mr. Moyer also submitted a Form 1120S for SLS for 2009, which Mr. Moyer was the sole owner of during 2009. He admitted that SLS had not earned a profit since at least 2004.
SLS reported losses on Forms 1120S for 2004 through 2009
In determining whether Calvin Moyer had an actual and honest objective of making a profit, the court first considered whether he conducted SLS's activity in a businesslike manner, as described in Regs. Sec. 1.183-2(b)(1).
Moyer testified that he did not attempt to determine SLS's expenses until the IRS issued its notices of deficiency. He also testified that he is "not good at keeping records." SLS neither kept contemporaneous records nor maintained a budget.
Moyer had no books or records from which he could evaluate SLS's profitability. SLS also did not file income tax returns for 2004 through 2009 but filed returns only in connection with Tax Court cases, several years after they were due. Asked whether failing to timely file income tax returns is a good business practice, Moyer responded: "It certainly isn't." All of these facts indicate a failure to conduct the activity in a businesslike manner, which in turn indicates the lack of a profit motive.
Although Moyer may have originally had a profit objective when he incorporated SLS in 1994, this was no longer true during the years in issue, the court held. By 2009, SLS was merely a convenient device by which the Moyers could try to deduct otherwise nondeductible personal expenses.
In both cases, the Tax Court found that the taxpayer had failed to demonstrate a clear profit motive, but the court looked at more than the fact that the business had losses for a string of years. As the cases show, it isn't simply the number of years in which a company took a loss that determines whether a taxpayer carried on a business with a profit motive; a court will also look at the motivation behind the business and the manner in which the taxpayer ran the business in determining whether the taxpayer had a profit motive.
Craig W. Smalley, MST, is an enrolled agent who is the founder and CEO of CWSEAPA, PLLC, which provides accounting and financial services.