Generally, expenses related to activities that are not engaged in for profit are not deductible.[2] In a recent memorandum opinion[3], the United States Tax Court reiterated the criteria upon which the Court considers if an activity is engaged in for profit. While the recent decision was not a landmark case[4], it provides some cautionary guidance for those taxpayers who have deducted expenses from an activity which, when applying the factors the Court iterates in this case, may not be deemed to be for profit. This is a subject we’ve written about in the past.[1]
Facts
The taxpayer was an avid fisherman who lived in Alaska for over thirty years. In 2010, the taxpayer retired from two separate jobs and established Happy Jack Charters, a guide service whereby the taxpayer would take clients to fish for halibut in Alaskan waters. The taxpayer established Happy Jack Charters in 2010, but he did not obtain the required permits to run such guide service until 2015. That year, he took five chartered groups. In 2016, the taxpayer took only six chartered groups. These eleven groups represented all of Happy Jack Charters’ clientele and revenue since its inception.
After audit, the IRS issued the taxpayer a notice of deficiency for tax years 2014, 2015, and 2016, on the grounds that the Happy Jack Charters was not a business engaged in for profit under Section 183. For these years in question, Happy Jack Charters earned $1,500, $2,345, and $3,709 in revenue, respectively, while deducting $1,993, $36,960, and $25,631 in expenses.
Law
Taxpayers are generally allowed deductions for business and investment expenses.[5] Under Section 183, however, if an activity is not engaged in for profit, taxpayers may only deduct expenses from the activity to the extent of the gross income derived from the activity.[6] The Regulations provide nine factors to consider when determining if an activity is for profit[7]:
- The manner in which the taxpayer carries on the activity;
- The expertise of the taxpayer or the taxpayer’s advisors;
- The time and effort expended by the taxpayer in carrying on the activity;
- The expectation that assets used in the activity may appreciate in value;
- The success of the taxpayer in carrying on other similar activities;
- The taxpayer’s history of income or loss with respect to the activity;
- The amount of occasional profits, if any, which are earned;
- The financial status of the taxpayer; and
- Whether elements of personal pleasure or recreation are involved.
None of these factors are given more weight than the others when determining if an activity is for profit, but rather all nine factors are considered given the facts and circumstances of the case on hand. In this case, the Tax Court found that eight of the nine factors weighed against the taxpayer.
Conducting an activity in a businesslike manner by maintaining complete records and conducting the activity in a manner similar to other activities of the same nature that are profitable is a factor that may indicate a profit objective.[8] Here, the taxpayer’s recordkeeping was limited to keeping receipts from his fishing trips, which he would give to his accountant to “figure it out.” The taxpayer did not have a separate bank account for Happy Jack Charters, nor did he have a business plan, or an idea how to correct the substantial losses reported on his returns for the years in question. The Court found that these facts cause factor #1 to weigh against the taxpayer.
The taxpayer had little to no personal experience running a business, and he did not engage any advisors to assist him in operating Happy Jack Charters. Even informal consultations with expert advisors demonstrate an intent to engage in a business for profit.[9] Here, however, the taxpayer failed to do so. The Court found that although the taxpayer was an expert fisherman, he was not an expert in running a business and failed to consult with expert advisors, and thus factor #2 weighed against him.
Devotion of a taxpayer’s personal time and effort to carry on an activity may indicate a profit motive, particularly if the activity does not involve substantial personal or recreational enjoyment.[10] The taxpayer took no chartered trips in 2014, and only five and six in 2015 and 2016, respectively. The Court found that the limited time the taxpayer spent on chartered trips indicated a lack of intent to make a profit, weighing factor #3 against him.
If a taxpayer has engaged in similar activities in the past and made them profitable, the success may show the taxpayer has a profit objective, notwithstanding the activity being currently unprofitable.[11] Conversely, a history of continued losses may indicate a lack of profit motive, and income from sources other than the activity may indicate the activity is not engaged in for profit.[12] Here, the taxpayer had never previously operated a fishing charter, and the taxpayer’s other ventures resulted in losses as well. Happy Jack Charters had produced a loss in every year since its inception, such losses totaling over $130,000. With these losses, the taxpayer relied entirely on income from other sources, namely from social security and his pension plan. For these reasons, the court found that factors #5, #6, #7, and #8 weighed against the taxpayer.
Lastly, the Court considered whether elements of personal pleasure or recreation were involved. Where the possibility of profit is small, and personal gratification is substantial, the Court has found the latter is the primary motivation for the activity.[13] Here, the taxpayer was an avid fisherman who took countless personal fishing trips on his boat. He went further to testify that his retirement plan was to live in small town Alaska and fish. Again, factor #9 weighed against the taxpayer. The Court concluded by holding that the taxpayer did not operate Happy Jack Charters with the requisite intent to make a profit, and he was thus only entitled to deduct expenses to the extent he derived gross income from Happy Jack Charters.
Conclusion
The taxpayer in this case took deductions many multiples over his income derived from his fishing charter business, and while the court believed he had genuine dreams of the business being a success, nevertheless found that his actions did not constitute a profit motive. While the lopsided facts in this case certainly support the Court’s decision, this case provides a cautionary tale to those who are taking deductions with relation to a hobby they hope becomes an eventual business.
[1] https://esapllc.com/the-importance-of-being-a-trade-or-business/; https://esapllc.com/besten2019/; https://www.esapllc.com/side-hustle-business-or-hobby/
[2] I.R.C. § 183(a).
[3] Swanson v. Comm’r, T.C. Memo. 2023-81.
[4] See Huff v. Comm’r, T.C. Memo. 2021-140; Walters v. Comm’r, T.C. Memo. 2022-17; Sherman v. Comm’r, T.C. Memo. 2023-63; and Wondries v. Comm’r, T.C. Memo. 2023-5.
[5] I.R.C. §§ 162, 212.
[6] I.R.C. § 183(a) & (b).
[7] Treas. Reg. § 1.183-2(b).
[8] Treas. Reg. § 1.183-2(b)(1).
[9] Engdahl v. Comm’r, 72 T.C. 659, 668 (1979).
[10] Treas. Reg. § 1.183-2(b)(3).
[11] Id.
[12] Id.
[13] Burger v. Comm’r, T.C. Memo. 1985-523.
