Small Business Taxes & ManagementTM--Copyright 2014, A/N Group, Inc.
IRS Challenges Artist's Business
The "hobby loss" issue has been around a long time. The IRS can challenge an activity with losses you've treated as a business as being a "hobby" under Section 183 by claiming you didn't intend to make a profit. In more than a few cases the challenge is legitimate--claiming to be a professional golfer when you're shooting a 93 on a good day. But many entrepreneurs genuinely seek to make a profit on their business, yet have years of losses. Often these cases end up in court and a judge decides the fate using nine factors described in the regulations. (For a discussion of the nine factors and more of the basics on hobby losses go to Hobby Losses.)
This case, Susan Crile (T.C. Memo. 2014-202), was out of the ordinary. The taxpayer was a professional artist and a tenured professor of studio art who, over a 40-year period, incurred losses in all but a few years. The facts are important, and the Court discussed them in much detail. We'll try to reduce that detail without reducing its importance. If you want to model your activities on the case (you're an artist, writer, etc.), you should read the case in its entirety.
The taxpayer had a long, varied, and distinguished career as an artist, working for more than 40 years in media that include oil, acrylic, charcoal, pastels, printmaking, lithograph, woodcut, and silkscreen. She has exhibited and sold her art through leading galleries; she has received numerous professional accolades, residences, and fellowships; and she is a full-time tenured professor.
During the academic year she devoted roughly 30 hours per week to her art in Manhattan. During the summer she worked full time at a larger studio in upstate New York. During her career she has created more than 2,000 works of art. Her artwork hangs in the permanent collections of at least 25 museums including the Metropolitan Museum of Art and the Guggenheim. Museum acquisitions increase an artist's reputation and may contribute to price increases for their works. In addition, the taxpayer's artwork has been acquired by for-profit as well as nonprofit entities such as Bank of America, General Mills, etc. as well as governmental entities. She has been represented by at least five New York art galleries.
The taxpayer actively marketed her artwork during the tax years at issue. She was represented by galleries which play a large marketing role for an artist. The taxpayer supplemented the galleries' efforts by sending exhibition announcements and other promotional material s to her mailing list of nearly 3,000 collectors. She regularly attended events to network with collectors, journalists, and art professionals. She used a Web site with images of selected works and has received inquiries through the Web site. She carefully documented her extensive inventory of artwork. Early in her career she used an index card system to record relevant information about each work including title, medium, dimensions, exhibition history, original asking price and if the work was sold, the gallery commission. (She recently switched to a computerized system.) The Court noted here sales records were generally accurate but sometimes incomplete. Maintaining perfect sales records was difficult because sometimes galleries neglected to provide her with all relevant information. In some cases she received a single check for the sale of multiple works without the purchaser's identity. When she received incomplete information she attempted to obtain relevant sales data from the gallery.
The taxpayer keep records of all invoices related to her art business and all receipts for business and personal expenses. During four of the five years at issue she hired a bookkeeper to assist her. The bookkeeper entered the data in Quicken. She provided the files to her accountant who prepared her tax returns.
The taxpayer has generated substantial income from sales of her artwork. The IRS stipulated the total value of works sold during her career is at least $937,150. Galleries usually took a 50% commission. The IRS stipulated that after commissions the taxpayer received at least $537,902 from the sale of 261 works between 1971 and 2013. The taxpayer and the IRS agreed that an additional 95 works were sold but the dollar value was approximated; the Court found the taxpayer received another $130,000. In all, the taxpayer received gross proceeds of $1,197,150 and net proceeds (after commissions) of $667,902 during these years. Despite substantial gross receipts, the taxpayer has never reported a profit. (A profit in 1995 was offset by a loss carryforward; a profit was anticipated in 2013.)
The taxpayer practiced as an artist before she began teaching, and it was achievements as an artist that resulted in her securing a teaching position. She began as a visiting assistant professor in 1983 and became a full professor in 1996. During the tax years at issue she earned between $85,999 and $106,058 annually from her teaching position. To be promoted and gain tenure, a studio artist must exhibit art; the sale of art is not required. A tenured professor is expected to continue to make and exhibit art, but the requirement is not rigorously enforced. The taxpayer plans to continue her art business following her retirement from teaching.
The taxpayer offered three expert witness to testify; the IRS one. Two of the experts noted that relatively few artists have steady, consistent sales from year to year or decade to decade and often experience income instability and one added many find it necessary to have another job with reliable income. One of the experts noted that the taxpayer handled her business with considerable care including her recordkeeping and treatment of her works. On the other hand, the IRS expert concluded that, on the basis of sales history and other factors that she identified, there appeared to be a limited commercial market for the taxpayer's works.
The Court noted that the taxpayer's theory for claiming deductions seemed to have been that most experiences an artist has may contribute to her art and that most people with whom an artist socializes may become customers or otherwise advance her career. The Court went on to say that a significant number of the deductions were not ordinary and necessary business expenses, but personal, living, or family expenses. They included telephone and cable bills, newspaper and magazine subscriptions, taxicabs to the opera, museums, and social events, restaurant meals with friends and acquaintances and international travel to gain inspiration from paintings in European museums. The Court deferred that issue to another day, but said it was clear her economic losses from her art business were substantially smaller than those reported on her return.
The Court noted that the whether the not-for-profit regulations apply to a particular activity, a determination must be made as to the scope of that activity, that is, whether the activity encompasses a single undertaking or multiple undertakings. Significant facts include (1) the degree of organizational and economic interrelationship of various undertakings; (2) the business purpose which is (or might be) served by carrying on the various undertakings separately or together; and (3) the similarity of the undertakings. For example, does the taxpayer's speedboat racing activity promote his marina? Here the IRS argued that her art activity wasn't separate from her business as an art professor. The two were a single activity and the expenses should be deducted on her individual return on Schedule A as a business expense. The Court dealt with that quickly, finding the two were separate activities, noting the taxpayer was an artist for 10 years before she began teaching and 25 years before she became tenured. While the college expected her to exhibit her work, it did not require that she sell art. Many of her marketing and related business activities were irrelevant to her teaching career, but were critical to a business. The Court noted the IRS did not explain why she would spend time on these tedious and unpleasant activities if her sole goal was to retain her teaching position.
The Court sought to determine if the taxpayer intended to earn a profit by applying the nine factors in the regulations. We'll provide the highlights of what the Court found in each of the nine factors.
Manner in Which Activity is Conducted. The taxpayer kept records that are substantially similar to, and in most respects superior to, those maintained by the taxpayer in a similar case, Churchman. The lapse in sales records was often due to circumstances beyond her control, such as failures by the galleries to provide her with data. While she did not have a written business plan, she had a plan and pursued it consistently. She understood the general factors that affected the price of art--a history of sales, gallery representation, critical reviews, etc. and worked to enhance her credentials. Advertising and marketing are important elements of a business plan. The representation by a gallery demonstrated she conducted her activity in the same manner as other professional artists. The records she kept of collectors and her networking further indicated a profit objective. The Court found this factor strongly favored the taxpayer.
Expertise of the Taxpayer and Her Advisors. There was no doubt the taxpayer ranks at the top of the scale in terms of expertise as an artist. The representation by galleries as well as sales to collectors and museums demonstrated that. She did not have professional business advisors, but the galleries who represented her were her principal advisors. The IRS questioned her expertise in the economics of being an artist. The Court found the taxpayer understood the general factors that affect the pricing of art and acted accordingly. The Court found this factor strongly favored the taxpayer.
Taxpayer's Time and Effort. The Court noted a taxpayer need not devote his or her full time to an activity. Having another job is acceptable. Here the taxpayer worked roughly 30 hours per week in her art business during the academic year and worked on it full time during the summer. That compared favorably with other cases where the taxpayer was found to be engaged in a trade or business. The Court noted that it has sometimes disregarded time spent on mundane tasks (such as grooming horses) where the task was essential whether the activity were a hobby or a business. Here the mundane tasks were marketing, networking, etc. and would be essential only if the taxpayer was conducting a business. This factor strongly favored the taxpayer.
Expectation of Appreciation in Value. An expectation that the assets will appreciate may indicate a profit motive. The expectation of appreciation becomes less speculative when a taxpayer shows actual success in an endeavor that could plausibly lead to appreciation. The IRS claimed the taxpayer did not show that appreciation in the value of her artwork could ever exceed her accumulated claimed losses. The Court noted this contention improperly focuses on actual rather than expected appreciation. The Court did not find the IRS's expert properly evalautated the potential for price appreciation. The Court noted the taxpayer had a large inventory of paintings (1,500) available for sale during the years at issue. The Court noted that prices paid for works by established artists often increase dramatically toward the end of their career. The Court held this factor favored the taxpayer, but less strongly than the previous three factors.
Taxpayer's Success in Other Activities. Success in other business ventures may indicate the taxpayer has the entrepreneurial skills to success in subsequent endeavors. The Court found that this factor had limited relevance here, but to the extent it did, it favored the taxpayer.
History of Income or Losses. The fact that a taxpayer incurs a series of losses beyond an activity's startup years may imply the absence of a profit objective. This factor takes into account losses due to customary business risks or reverses or to unforeseen or fortuitous circumstances beyond the taxpayer's control. The Court noted that because it often takes may years to achieve economic success in the creative arts, it has found that a history of losses is less persuasive in the art field than it might be in others. The Court found this factor favored the IRS.
Amount of Occasional Profits. Clearly the taxpayer's losses were substantial with only two years of profits, but the Court noted success in the art world is very hard to predict and that a single event--a solo show, a rave review, or a museum acquisition--can lead, fairly suddenly, to an exponential increase in the prices paid for an artist's work. This factor favored the IRS, but not terribly heavily.
Taxpayer's Financial Status. If a taxpayer lacks substantial income or capital other sources that may indicate a profit motive. Here the Court found her art business was her primary activity. This factor was found to be neutral, favoring neither party.
Elements of Personal Pleasure. Deriving personal pleasure from the activity may suggest the lack of a profit motive. The derivation of personal pleasure is not sufficient to suggest the lack of a profit motive if other factors suggest a profit motive. The Court found this factor neutral or slightly favoring the taxpayer.
After weighing the factors, the Court found the taxpayer was engaged in the trade or business of being an artist.
The Good News.The taxpayer won her case. The important takeaway here is that the Tax Court recognizes that artists are different and it can them take considerable time to turn a profit. The Court was certainly willing to recognize that when analyzing two of the factors. Of importance here, the Court recognized that the losses could extend over a long period of time. Had the activity been another type of business such as a restaurant, it's unlikely the Court would not have been so forgiving.
The Bad News. The taxpayer clearly made a substantial effort to become profitable, or at least improve her standing in the art world. She keep records far beyond what many taxpayers would have, she aggressively marketed her art and herself, and she was well recognized in the art world. During the years at issue the taxpayer was far from the realm of a struggling artist trying to sell her first painting. She bore no resemblance to the author whose first two books never reached the market and is about to break 1,000 copies on his third. She had considerable statue in the field and experience in her craft. In fact, her string of losses created the only two factors that were not in her favor. A beginning artist would find it much harder to convince a court of a profit motive. From the tone of the case it appeared her recordkeeping and marketing efforts impressed the Court. That's rare. This is where most taxpayers fail.
Setting up Your Case. The taxpayer has the initial advantage in these cases in that he or she can create a fact pattern that will bolster their position in court. Unfortunately, it requires the actions few want to take. Keeping meticulous records, seeking outside guidance, developing a plan, changing strategies when the initial plan doesn't work, etc. Without doing so for tax reasons, that's exactly what the taxpayer did here, creating a fact pattern that put her in a favorable position in court. That's why we spent so much time describing the facts. Should you find your business challenged because of a string of losses you should consider trying to convince the IRS (and the court) that this type of business can take more than a few years to turn profitable. In truth, the programmers who wrote that killer app and become instant millionaires are the exception, not the rule.
For more information, see our article Hobby Losses.
Copyright 2014 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. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 11/18/14