Small Business Taxes & ManagementTM--Copyright 2007, A/N Group, Inc.
Many taxpayers try to combine business with pleasure. There's nothing inherently wrong with that. If you enjoy carpentry, why not make it a business? The IRS gets into the act when the activity losses money consistently or looks a little too pleasurable. Classic cases where taxpayers have been challenged by the IRS involve high earning individuals who claim deductions for losses from horse breeding, farming, auto racing etc. And you can't escape the rules by simply combining activities in one entity. For example, running a farm in the same S corporation that's used to operate an auto parts business. The IRS can look at each activity separately.
Some taxpayers have claimed losses related to other activities had a valid business purpose of supporting the taxpayer's main activity. For example, auto racing as advertising for a taxpayer's chain of auto repair shops. Some taxpayers have been successful; others not. It depends heavily on how closely the two activities are related.
In a recent case, Tracey L. Topping (T.C. Memo. 2007-92) the taxpayer bested the IRS by convincing the Tax Court her equestrian activities were necessary advertising for her business of designing horse barns and homes. The facts are important here, but we'll just present the highlights. The taxpayer had just divorced and needed to support herself. She had not worked for a number of years, but was an experienced equestrian who had competed on an amateur level for some time and had the ability to draft structural designs freehand. She developed a plan to persue her prominence in the equestrian world to build a business designing horse barns and homes. Her plan was to establish and maintain herself as a peer worthy of trust among the exceptionally wealthy families who participate in the upper realms of the equestrian circuit, own multiple residences, and use interior designers. Even though she had no written business plan, she discussed her plan for her business venture with her CPA. She also discussed her plan with a longtime friend who had successfully started her own business. The taxpayer did not conduct a formal market study, nor did she prepare any cashflow projections in anticipation of starting her new business. She formed an LLC, Topping White Design, LLC.
The taxpayer hired an assistant for general administrative work and to schedule contractors. She relied on trainers both to refer clients and improve her performance as a competitor. Every one of the trainers she worked with referred at least one design client to the taxpayer. The taxpayer's business methodology consists of entering in and attending horse shows, and making contacts with prospective clients at the shows. Potential clients develop from horse show contacts, and then the taxpayer meets with the potential client. Early on in her business, the taxpayer tried to develop clients through her longtime experience playing golf. When golf failed to produce any clients, she dropped her golf club membership.
The taxpayer developed her equestrian contact clients for Topping White while competing during the Winter Equestrian Festival, which takes place at the Jockey Club. The Jockey Club consists of a large concentration of extraordinarily wealthy people. Most of the attendees in the Jockey Club own horses, and all come to watch the equestrian competition. Tables are reserved at the beginning of the season. The cost of a table reservation rose from $5,000 for the 7-week season to $25,000. The taxpayer originally owned a table at the Jockey Club, but when the cost increased, she initially split the cost with one client, and then later split the cost with two clients. The taxpayer's name is generally announced several times over the loudspeaker and posted on a leaderboard during the competition. The taxpayer testified that she has to maintain the reputation she has cultivated as a skilled competitor in order to keep her existing relationships and to cultivate new ones. The Court found the taxpayer's testimony plausible. The taxpayer does not advertise her interior design business through advertising media such as equestrian-related magazines, Web sites, or newspapers. In addition, she does not display banners or sponsor any events through Topping White. The taxpayer intentionally rejects this type of advertising because the ethos of the Jockey Club and its members perceive that kind of generic advertising of a personal service business as tacky or gauche. In addition, she does not want to convey the impression that she is desperate for or needs the work. Rather, she relies on her exposure and reputation as both a rider and owner, and also her popularity among the members of the Jockey Club. Instead of actively seeking new clients, she adopts a more subtle approach to attracting prospective clients by making herself available at the Jockey Club during key times in order for prospective clients to find her. In addition, she also relies on word of mouth and referrals by members of the Jockey Club.
The taxpayer uses QuickBooks to keep records for both the equestrian and interior design activities on a consolidated basis. She does not keep records of training costs or costs associated exclusively with horse shows for the purposes of projecting a budget. Nor does she or her CPA prepare monthly budgets or cashflow projections for either the interior design or equestrian activities. According to the taxpayer, that is because there is no way to predict what those costs will be from month to month, and that the equestrian circuit is not her business but is part of her overall plan to develop her interior design clientele. At trial, the taxpayer produced documentary evidence of a profit or loss statement prepared by CPA that tracked expenses for both her equestrian and interior design activities.
The IRS disallowed the expenses related to the taxpayer's equestrian activities and disallowed some of the expenses related to her interior decorating activity, noting that some of the expenses were not substantiated and some were disallowed as not ordinary and necessary business expenses.
Before addressing whether the taxpayer had the requisite profit motive based on the facts and circumstances, the Court first addressed the threshold issue of whether the taxpayer's equestrian and design undertakings constituted a single activity for purposes of deciding whether she had the requisite profit motive under Section 183. The Court believed in this case that the resolution of that issue skews all of the remaining issues in favor of the party who prevails. The taxpayer's arguments for profit motive all revolve around the assumption that the undertakings constitute one activity, while the IRS's arguments isolate the equestrian undertaking and its losses to argue that the taxpayer did not have the requisite profit motive.
Multiple undertakings of a taxpayer may be treated as one activity if the undertakings are sufficiently interconnected. (Sec. 1.183-1(d)(1), Income Tax Regs). The most important factors in making this determination are the degree of organizational and economic interrelationship of the undertakings, the business purpose served by carrying on the undertakings separately or together, and the similarity of the undertakings. The IRS generally accepts the taxpayer's characterization of two or more undertakings as one activity unless the characterization is artificial or unreasonable.
The Court considered these and other factors in determining whether the taxpayer's characterization is unreasonable. The other factors considered include:
The Court found the taxpayer's characterization of the equestrian and design undertakings as a single activity for purposes of Section 183 to be supported by the facts of this case. A close organizational and economic relationship exists between the equestrian and design undertakings. The taxpayer's success as an equestrian competitor creates goodwill that benefits her design business. She formed the equestrian and design undertakings as a single integrated business. The taxpayer had been a competitor for most of her adult life, and she transformed this sport experience into an avenue to establish goodwill as an interior designer of horse barns and second homes. She had a plan for an integrated equestrian-based design business. The taxpayer used the same books and records to track both undertakings. Further, her equestrian activities significantly benefited her design business and the Court found a significant business purpose for the combination of the undertakings.
The IRS faulted the taxpayer for not advertising in a conventional sense, such as putting up ads in equestrian magazines or banners at horse shows, arguing that the taxpayer's failure to specifically advertise through conventional media is indicative of the lack of an economic relationship between the two undertakings. However, the taxpayer testified and had witnesses corroborate that traditional advertising of a personal service business is not welcomed by the clientele the taxpayer sought. The question is not whether a particular mode of doing business is wise, but whether the taxpayer honestly believed the method employed would turn a profit. The Court noted that equestrian clients accounted for more than 90 percent of her client base and her business produced a significant net profit.
The IRS cited several cases where the Tax Court held that the activities could not be aggregated. The Court countered that the cases were not analogous to the taxpayer's situation. None of the activities in those cases have the same level of integration and interdependence that the taxpayer's equestrian and design activities did. The Court was persuaded that her equestrian activities were necessary to the success of her design business. The evidence showed that the taxpayer's interior design business materially benefits from her equestrian related activities, which is consistent with the distinctions made between incidental and material benefit.
The Court noted that for the years at issue, the taxpayer's CPA reported the activities on two separate Schedules C. Positions taken by a taxpayer in a tax return are treated as admissions and cannot be overcome without cogent proof that they are erroneous. Based on the plethora of evidence that the two undertakings constitute a single activity, the Court found that the taxpayer overcame that position.
The Court found that a close organizational and economic relationship exists between the equestrian and the design undertakings. Accordingly, for purposes of Section 183, the equestrian undertaking and the design operation constitute a single activity. The Court did not consider whether the taxpayer engaged in the equestrian-based design business with the objective of making a profit because the combined activities were profitable in each of the years at issue.
The IRS also argued that even if the equestrian and design undertakings were a single activity and that the taxpayer had a profit motive, she failed to establish all the expenses were ordinary and necessary. And, even if the expenses are ordinary and necessary, they are deductible only if they are reasonable in amount.
The Court noted that expenses for personal pursuits do not become deductible expenses simply because they afford contacts with possible future clients. The taxpayer proved that her equestrian activities are necessary to her success as an interior designer. The unique nature of her design business made it an ordinary expense to partake in equestrian-related activities to achieve the peer acceptance to attract clients. The Court found that the taxpayer's design and equestrian activity is part of an integrated business plan and that her clientele is almost exclusively derived from her equestrian contacts. The taxpayer also offered corroborating testimony that individuals in service businesses who use conventional advertising evoke a negative reaction from the people at the Jockey Club. The IRS's arguments focus on the taxpayer's means to an end, but neglect the most important fact of all--the taxpayer's plan worked. Her startup business was a success from the beginning and continues to be successful, and has credibly demonstrated that the measures she takes to build her client base are both ordinary and necessary.
The Court went on to say the evidence does not establish and the IRS has not argued convincingly that any particular expense was unnecessary or excessive. Obviously, keeping and maintaining horses is expensive. The taxpayer demonstrated that she has done what she can to keep costs down, from choosing less expensive travel to sharing the cost of a table at the club. The IRS offered numerous ratios of the expenses associated with the equestrian activities to the profit from Topping White. The taxpayer does what is necessary to maintain her reputation in the equestrian world, and we find that she does not do so in an extravagant manner. The fact remains that petitioner's design business depends heavily on her equestrian-related activities for its success. The Court held the taxpayer's equestrian expenses ordinary and necessary, but that they were reasonable in amount.
The taxpayer won her case, but most taxpayers aren't going to be as lucky. It's usually tough convincing the IRS of the relationship between two normally unrelated activities. And even if the two look similar on the surface, you'll still have to convince the IRS or a court that one business significantly benefitted from the other activity. For example, you own a chain of auto parts stores. Painting Madison Auto Parts all over a dragster and going to the track won't guarantee a deduction for the racing expenses. The IRS can argue, as it tried in the case above, that you could have done better using conventional advertising. To counter the argument, be prepared to show the value of activity to your business. And, if you're racing cars, it helps to win.
Don't wait until you get a letter from the IRS. You can bolster your case significantly if you structure the facts to coincide with your position. For example, in the case above the taxpayer switched from golf to her equestrian activity when it was clear golf wasn't bringing in clients. She tried to keep her costs in check. She keep books and records on the activity and consolidated them with her business. You can't take these actions some years down the road when the IRS questions them.
Review the list of factors presented in the case above. Discuss them with your tax adviser. Each case is unique. The IRS may be looking more closely at such activities. It recently released Fact Sheet FS-2007-18 concerning hobby losses and noted the government loses some $30 billion a year on the issue.
Copyright 2007 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
--Last Update 04/30/07