TALE OF TWO TAX COURT CASES - HOBBY LOSS RULES

[Lee B]

FROM FORBES by Tony Nitti

A Tale Of Two Activities: How To Beat The Hobby Loss Rules

 

Over the weekend, I regaled you with the ballad of Susan Crile, who landed in front of the Tax Court after the IRS alleged that her 40-year run as an accomplished artist amounted to nothing more than a “hobby.” Crile came away victorious; you can read all about it here.

 

The Crile case attracted quite a bit of attention from the art community because it provided some useful guidance on how aspiring artists can strengthen the position that their  activity rises to the level of a trade or business. Today, the Tax Court took on another hobby loss case that should be of great interest to a specific sect of the population; namely, those odd yet loveable man-children who continue to collect baseball cards long after reaching adulthood. This case did not end well for the taxpayer, with the court concluding that his memorabilia activity was a hobby.  

 

In Akey, the taxpayer had a day job as a quality insurance engineer, earning over six-figures in 2001, 2002 and 2003. During those years, the taxpayer also generated large net losses ranging from $$97,000 to $143,000 from a sports memorabilia activity that he conducted and reported on Schedule C. As you’ve probably realized by now, this didn’t end well because, well…Day Job Income -  Large Schedule C Losses + Recreational Nature of Second Activity = IRS “Hobby Loss”

Audit.

 

 On it’s own, the decision in Akey isn’t particularly enlightening or memorable. When we take a step back and compare the facts and Tax Court analysis in Akey and Criles, however, we start to get a clear picture of what we should do — and, much more importantly, not do — to beat the hobby loss rules.

 

As a reminder, the distinction between trade or business and hobby is an important one. A trade or business can deduct its expenses in excess of its income, thereby generating a net loss that can be used to offset other income. A hobby, to the contrary, can only deduct its expenses to the extent of its income, and is thus incapable of producing a net loss. 

 

Last week, I introduced the nine factors provided in the regulations to help determine if an activity is a trade or business or a hobby. And while no one factor is determinative, by identifying a couple of key factors where Akey and Criles handled their activity with varying degrees of formality, we can learn a few things.    

 

Factor #1. The manner in which the taxpayer carries on the activity. Does the taxpayer complete accurate books? Were records used to improve performance? 

 

In Crile, the taxpayer kept detailed records, including the sale price and identity of the buyer of one of her works. She hired a bookkeeper, and used the resulting financial records to market her works to collectors, galleries, and museums. She tracked her inventory carefully and conducted extensive marketing efforts. To enhance her profitability, she switched art galleries and tried new media.

In Akey, the taxpayer failed to maintain complete and accurate books and records. He did not hire a bookkeeper. He did not prepare budgets, income statements, balance sheets, forecasts or any other financial statement that he could utilize to help improve his bottom line. He failed to undertake any steps to improve his profitability. All of this was within the taxpayer’s control, and by failing to conduct his memorabilia activity in a businesslike manner, he did himself no favors. While you can’t win a hobby loss case on the first factor, you can certainly lose it here, and that’s likely what happened here.

 

Factor #2. The expertise of the taxpayer or his advisers. Did the taxpayer study the activity’s business practices? Did he consult with experts?  

 

In Crile, the taxpayer was an acclaimed artist with works hanging in many major museums, board rooms, and governmental buildings. She had over 40 years of experience and had sold over 200 pieces totaling over $1,000,000 in sales price.

 

In Akey, the taxpayer did nothing to acquire expertise in baseball card collecting aside from purchasing price guides, which as the court pointed out, is pretty much the one mandatory acquisition for anyone interested in buying and selling cards, even if it were merely as a hobby. As a result, this purchase did nothing to differentiate his activity as a business. While not everyone can achieve the level of success enjoyed by Crile, the taxpayer in Akey could have established that he routinely attended trade shows, conducted sophisticated research, and consulted with industry experts about buying and selling tactics to bolster his argument that his activity was a business.

 

Factor #3. The time and effort expended by the taxpayer in carrying on the activity. Does she devote much of her personal time and effort?  

 

In Crile, the taxpayer spent over 30 hours per week – over a 40-year span — working on her art. In addition, she spent a great deal of time on the mundane tasks that tend to separate business from hobby, such as marketing and networking.

 

In Akey,  the taxpayer testified that he spent 15 hours a day, every day, on his memorabilia activity. And yes, this was in addition to his regular full-time job. If we do the math, assuming his full-time gig was a 9-5er, the taxpayer asserted that he worked 23 hours a day from Monday through Friday, an outlandish, ridiculous claim that can only be rivaled by, well…pretty much every CPA I’ve ever worked with.   Because the claim was so preposterous, the Tax Court ignored it. The lesson? Be reasonable, but also establish that you work very hard at your activity by showing the results of your research, and proving participation at conferences, conventions, and networking events.

 

Factor #4. The expectation that the assets used in the activity may appreciate in value. Is the plan to generate profits through asset appreciation?  

 

In Crile, the taxpayer tracked her inventory in great detail, and took care to make sure it was secure and adequately preserved in hopes of maximizing a future sales price.  

 

In Akey, the taxpayer could not even produce an itemized list of the individual items he held in his inventory, meaning he had no apparent means of tracking which items to hold and which to sell. Don’t do that.

 

Factor #6. The taxpayers history of income or losses with respect to the activity.  Has the taxpayer become profitable in a reasonable amount of time?  

In Crile, the taxpayer had a long history of losses, though the Tax Court

noted that the start-up period is generally longer in the arts. More damning, however, was that she appeared to greatly overstate her expenses, claiming deductions for what appeared to be numerous personal items that will land her back in the Tax Court soon.

 

In Akey, the taxpayer took the inspired approach of blaming his history of losses on steroids, arguing that the PED era devalued his entire inventory and resulted in his large losses.  The Tax Court was unmoved, though it’s not as ridiculous an argument as it may seem, and probably should have been given a little more weight by the court.

 

We already knew how these two stories ended: Crile won, Akey lost. By going through these few factors, however, you should hopefully see that while Akey couldn’t be expected to have the same level of skill and experience as Crile, he could have taken steps within his control to strengthen his position that his baseball card activity was a trade or business.

 

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