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Thursday, December 20, 2012
section 183 hobby loss case
John A. Sernett v. Commissioner, TC Memo 2012-334 , Code Sec(s) 183; 7491.
JOHN A. SERNETT, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent .
Code Sec(s): 183; 7491
Docket: Docket No. 25295-10.
Date Issued: 12/3/2012
Reference(s): Code Sec. 183; Code Sec. 7491
Official Tax Court Syllabus
Michael J. Dwyer, Ward Rollin Anderson, and Rebecca S. Christensen, for petitioner.
II. Whether Sternett Motorsports Was Operated for Profit A. Section 183 Generally A taxpayer who is carrying on a trade or business may deduct ordinary and necessary expenses incurred in connection with the operation of the business. Sec. 162(a). However, a taxpayer generally may not deduct expenses incurred in connection with a hobby or other nonprofit activity to offset taxable income from other sources. Sec. 183(a) and (b). Section 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.” An activity constitutes a “trade or business” within the meaning of section 162 if it is conducted with continuity, regularity, and for the primary purpose of realizing income or profit. Commissioner v. Groetzinger, 480 U.S. 23, 35 [59 AFTR 2d 87-532] (1987). The U.S. Court of Appeals for the Eighth Circuit, to which an appeal in this case would lie absent a stipulation to the contrary,see, sec. 7482(b)(1)(A), (2), has stated that "[a]n activity is engaged in for profit if the taxpayer has an actual, honest profit objective, even if it is unreasonable or unrealistic.” Keating v. Commissioner, 544 F.3d 900, 904 [102 AFTR 2d 2008-6638] (8th Cir. 2008), aff'g [*11] T.C. Memo. 2007-309 [TC Memo 2007-309]; see also sec. 1.183-2(a), Income Tax Regs. Whether the requisite profit objective exists is determined by looking at all the facts and circumstances, Evans v. Commissioner, 908 F.2d 369, 373 [66 AFTR 2d 90-5500] (8th Cir. 1990), rev'g T.C. Memo. 1988-468 [¶88,468 PH Memo TC]; sec. 1.183-2(a), Income Tax Regs., and greater weight is given to objective facts than to a taxpayer's statement of intent,Thomas v. Commissioner, 84 T.C. 1244, 1269 (1985), aff'd, 792 F.2d 1256 [58 AFTR 2d 86-5138] (4th Cir. 1986); sec. 1.183-2(a), Income Tax Regs.
Section 1.183-2(b), Income Tax Regs., provides a list of factors to be considered in the evaluation of a taxpayer's profit objective: (1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on similar or dissimilar activities;
(6) the taxpayer's history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, from the activity; (8) the financial status of the taxpayer; and (9) elements of personal pleasure or recreation. This list is nonexclusive, and the number of factors for or against the taxpayer is not necessarily determinative. Rather, all facts and circumstances must be taken into account, and more weight may be given to some factors than to others. See Dunn [*12] v. Commissioner, 70 T.C. 715, 720 (1978), aff'd, 615 F.2d 578 [45 AFTR 2d 80-683] (2d Cir. 1980); sec. 1.183-2(b), Income Tax Regs.
B. Petitioner's Racing Activity
We apply the factors listed in section 1.183-2(b), Income Tax Regs., as follows.
1. The Manner in Which Petitioner Conducted the Activity In deciding whether a taxpayer has conducted an activity in a businesslike manner we consider whether the taxpayer: (1) maintained complete and accurate books and records; (2) conducted the activity in a manner substantially similar to other activities of the same nature that were profitable; and (3) changed operating methods, adopted new techniques, or abandoned unprofitable methods in a manner consistent with an intent to improve profitability. See Engdahl v. Commissioner 72 , T.C. 659, 666-668 (1979); sec. 1.183-2(b)(1), Income Tax Regs.
Petitioner contends that he operated Sernett Motorsports in a businesslike manner by (1) investing heavily in capital assets, (2) analyzing his performance after each season, (3) consulting with various advisers, (4) racing only in races offering significant prize money, (5) maintaining accurate records, and (6) maintaining a separate checking account for Sernett Motorsports. Respondent contends that Sernett Motorsports was not operated in a businesslike manner [*13] because petitioner (1) failed to maintain comprehensive books and records for evaluating his racing activity, (2) lacked a written or credible business plan, (3) commingled his personal funds with his business funds in Sernett Motorsports' checking account, and (4) failed to take steps to reduce costs or to increase profitability.
Although petitioner invested heavily in capital assets, such investment is consistent with respondent's theory that petitioner's racing activity was simply an expensive hobby. Petitioner kept accurate records, but he seemingly did so to satisfy the Code's recordkeeping requirements rather than as a tool to achieve profitability. See Golanty v. Commissioner, 72 T.C. 411, 430 (1979), aff'd without published opinion, 647 F.2d 170 (9th Cir. 1981); Nissley v. Commissioner, T.C. Memo. 2000-178 [TC Memo 2000-178], 79 T.C.M. (CCH) 2105, 2110 (2000). Similarly, petitioner testified that he consulted with his C.P.A. regarding various tax matters but he could not testify with specificity regarding any financial advice that his C.P.A. may have provided. We find, however, that there is no indication that he commingled his personal funds with those of his racing activity.
Petitioner obtained marketing materials from a professional design firm to help secure corporate sponsorships for Sernett Motorsports. These materials indicate that he operated Sernett Motorsports in a businesslike manner. [*14] Petitioner did not have a written business plan during the years in issue. Petitioner's lack of a written business plan indicates that he did not operate Sernett Motorsports in a businesslike manner.
We find credible petitioner's testimony that he tried to minimize expenses and maximize his chances of winning races. However, this is also consistent with respondent's theory that petitioner's racing activity was an expensive hobby. Sprint car racing is a competitive sport, and petitioner, no doubt, did whatever he could to win races and minimize his expenses.
In short, petitioner conducted Sernett Motorsports in a manner consistent both with the operation of a profit-seeking enterprise and with the enjoyment of an expensive hobby. Accordingly, this factor is neutral.
2. The Expertise of Petitioner or His Advisers Preparation for an activity by an extensive study of its accepted business, economic, and scientific practices, or consultation with those who are experts therein, may indicate a profit objective. Engdahl v. Commissioner , 72 T.C. at 668; sec. 1.183-2(b)(2), Income Tax Regs. Efforts to gain experience and a willingness to follow expert advice may also indicate a profit objective. See, e.g., Dworshak v. Commissioner, T.C. Memo. 2004-249 [TC Memo 2004-249], 88 T.C.M. (CCH) 403, 406 (2004). [*15] Petitioner contends that his expertise and the expertise of those with whom he consulted are indicative of a profit motive. Respondent contends that petitioner lacked expertise with respect to creating a profitable racing enterprise and failed to seek advice from experts on making Sernett Motorsports profitable.
Petitioner has a bachelor's degree in business administration from Creighton University and is a successful salesperson. He managed a racing team for C.L. Boyd during the early 1980s and raced sprint cars for others for 15 years before starting his own sprint car racing activity. Since then petitioner has been racing for and managing Sernett Motorsports. Petitioner regularly consulted with a close network of sprint car racing enthusiasts, frequented racing supply shops, and attended the Performance Racing Industry Trade Show in Orlando, Florida. We are satisfied that petitioner had the requisite expertise to run a sprint car racing business. Accordingly, this factor favors petitioner.
3. Petitioner's Time and Effort Devoted to the Activity The fact that a taxpayer devotes personal time and effort to carry on an activity may indicate an intention to derive a profit, particularly where there are no substantial personal or recreational elements associated with the activity. Sec. 1.183-2(b)(3), Income Tax Regs. [*16] Petitioner contends that he spent significant time racing and preparing to race and reduced the hours he worked for NACR during the racing season. Respondent contends that petitioner's testimony with respect to the amount of time he spent on his racing activity is uncorroborated and self-serving and that it is anyway insufficient to show that his racing activity was conducted with a profit motive.
Petitioner credibly testified that he spent 15-20 hours during the week before a racing event preparing for the event. Petitioner explained that he disassembled the cars after each race and then cleaned, inspected, and replaced various parts, as required. He credibly testified that, during the years in issue, he raced between 10 and 16 weekends per racing season 6 and that he traveled to events up to five hours away from his shop in Lakeville, Minnesota. Petitioner also credibly testified that he reduced the number of hours that he spent working for NACR from 40-50 per week during the off-season to 20-25 per week during the racing season.
Although, as we find infra pp. 26-27, petitioner enjoys racing, we find that petitioner also spent significant personal time and effort preparing his cars for [*17] racing events. See Foster v. Commissioner, T.C. Memo. 2012-207 [TC Memo 2012-207], slip op. at 18. Additionally, petitioner significantly reduced the hours he spent working his lucrative, fully commissioned job for NACR so that he could prepare his cars for racing events. Accordingly, this factor favors petitioner.
4. Expectation That Assets Used in the Activity May Appreciate An activity may produce an overall economic profit, even if there is no operational profit, when appreciation of the assets of the activity is taken into account. Sec. 1.183-2(b)(4), Income Tax Regs.
Petitioner contends that his equipment should not have to appreciate for him to show a profit motive. Respondent contends that petitioner introduced no evidence that his equipment appreciated, and the record supports an inference that petitioner's equipment was not appreciating.
Petitioner has introduced no evidence that any of his racing equipment or assets appreciated. See Rule 142(a)(1). However, the absence of asset appreciation does not indicate that petitioner lacked a profit motive. See Foster v. Commissioner, slip op. at 19. Accordingly, this factor is neutral. [*18] 5. Success in Carrying On Similar or Dissimilar Activities The fact that a taxpayer engaged in similar activities and converted them from unprofitable to profitable enterprises may indicate that the taxpayer is engaged in the present activity for a profit, even though the activity is presently unprofitable. Sec. 1.183-2(b)(5), Income Tax Regs.
To support his contention that he had success in carrying on similar activities, petitioner merely points to his experience in the racing industry. Respondent contends that petitioner produced no evidence showing that he successfully operated similar activities.
Petitioner has introduced no evidence showing that he engaged in similar activities and converted them from unprofitable to profitable enterprises. See Rule 142(a)(1). Accordingly, this factor is neutral. See Pirnia v. Commissioner, T.C. Memo. 1989-627 [¶89,627 PH Memo TC], 58 T.C.M. (CCH) 740, 743 (1989).
6. Petitioner's History of Income or Loss From the Activity A taxpayer's history of income or loss with respect to an activity may indicate the presence or absence of a profit objective. See Golanty v. Commissioner, 72 T.C. at 426; sec. 1.183-2(b)(6), Income Tax Regs. However, a series of startup losses or losses sustained because of unforeseen circumstances beyond the control of the taxpayer does not necessarily indicate a lack of profit [*19] motive. Engdahl v. Commissioner 72 T.C. at 669; Kahla v. Commissioner, , T.C. Memo. 2000-127 [TC Memo 2000-127], 79 T.C.M. (CCH) 1846, 1852 (2000), aff'd without published opinion, 273 F.3d 1096 [88 AFTR 2d 2001-6055] (5th Cir. 2001); sec. 1.183-2(b)(6), Income Tax Regs.
Respondent contends that (1) petitioner's racing activity has produced persistent and significant losses since 1992 and (2) petitioner's use of his racing activity to boost his sales performance with NACR contradicts his claim of a profit motive for his racing activity.
Sernett Motorsports lost money from 1992 through 2009. From 2000 through 2007 Sernett Motorsports had gross receipts of $199,963, total expenses of $770,677, and total losses of $570,714. This history of significant, sustained losses is persuasive evidence that petitioner did not operate Sernett Motorsports with a profit motive. See Golanty v. Commissioner, 72 T.C. at 427. 7 [*20] To rebut this evidence petitioner points to his success as a salesperson for NACR, arguing that some of this success is attributable to his operation of Sernett Motorsports. 8titioner credibly testified that part of his success as a salesperson was attributable to his operation of Sernett Motorsports. Petitioner explained that he used Sernett Motorsports as a “marketing, promotional, bonding vehicle” and that he used the racing activity to build long-term relationships with his telephone equipment buyers. Petitioner introduced emails showing that he used Sernett Motorsports as a marketing tool, and NACR's president and CEO, Thomas M. Roles, wrote in a letter dated April 29, 2008, that “Sernett Motorsports has a direct contribution to *** success in the telephone equipment business from a marketing standpoint and is an important part of his overall success as a sales representative”. We therefore find that petitioner continued operating Sernett Motorsports, at least in part, because Sernett Motorsports helped him succeed in his job as a salesperson for NACR.
Although Sernett Motorsports may have increased petitioner's income from NACR, the significant, sustained losses that it produced indicate that petitioner did [*21] not operate Sernett Motorsports with a profit motive. See Morken v. Commissioner, T.C. Memo. 1986-535 [¶86,535 PH Memo TC], 52 T.C.M. (CCH) 969, 972 (1986). To the contrary, petitioner's belief that his racing activity increased his income from NACR lessened his concern about his losses from Sernett Motorsports. See id. 9 Moreover, petitioner's generalized belief that his racing activity helped increase his income as a salesperson is insufficient to overcome the objective evidence of significant, sustained losses from 1992 through 2009, particularly when petitioner could not quantify the effect of the racing activity on his commission income.
Petitioner does not contend, and the record does not suggest, that Sernett Motorsports' significant, sustained losses were startup losses or losses sustained because of unforeseen circumstances beyond his control. Accordingly, this factor favors respondent.
7. Amount of Occasional Profits
The amount of profits earned in relation to the amount of losses incurred, the amount of the investment, and the value of the assets in use may indicate a profit objective. See sec. 1.183-2(b)(7), Income Tax Regs. The opportunity to earn substantial profits in a highly speculative venture may be sufficient to [*22] indicate that the activity is engaged in for profit even though only losses are produced. See id.
Petitioner contends that he had opportunities to earn significant profit from prize money and sponsorship contracts. Respondent contends that petitioner's claimed expectations for earning significant profit were unrealistic. a. Prize Money Sernett Motorsports earned $31,430 in prize money during the years in issue. The $15,000 purse structure that petitioner typically raced for had a top prize of $2,250 and a second prize of $1,750. Petitioner testified that, had he placed higher in the events, he could have earned between $225,000 and $350,000 in prize money during the years in issue. 10 However, petitioner testified that, before the years in issue, he raced in the Knoxville Nationals for a top prize of $140,000 but that he had stopped racing in that event because he did not feel that he was “competitive enough to make money at that event.” Petitioner also testified at trial, in March 2012, that he expected to earn prize money of approximately $25,000 in 2012. [*23] As petitioner's reason for not competing in the Knoxville Nationals during the years in issue and petitioner's more modest expectations for the then-upcoming 2012 racing season show, petitioner is capable of rationally judging his competitiveness. Additionally, we find that petitioner could not have rationally expected that Sernett Motorsports would earn significantly more prize money than it earned during the years in issue. b. Sponsorships Sernett Motorsports earned $6,050 in corporate sponsorships from two local businesses during the years in issue. Petitioner testified that he also sought more lucrative sponsorships but was ultimately unsuccessful. Petitioner testified with some detail regarding two of his proposals.
With respect to the first proposal, petitioner testified that he pursued a $125,000, three-year sponsorship from Tires Plus in May 2004. Petitioner further testified that he believed that he had a good chance of obtaining the sponsorship from Tires Plus and that the proposal was dropped when Bridgestone acquired Tires Plus in fall 2004. However, in a summary of his solicitations of corporate sponsorships for Sernett Motorsports, petitioner wrote that he met with Tires Plus in April 2003. Additionally, the written proposal for the sponsorship from Tires Plus states that petitioner was then employed as a national account manager for [*24] Progressive, and NACR acquired Progressive in 2003. The written proposal also states that petitioner had 25 years of racing experience. Petitioner started racing in 1975, giving him 25 years experience by 2000. The proposal also has several dated quotes, and all of them predate 2000. 11 Accordingly, although we are satisfied that petitioner proposed a sponsorship to Tires Plus, the record does not reliably establish when this proposal was made.
With respect to the second proposal, petitioner testified that he pitched a corporate sponsorship proposal to Jack Links in Laurens, Iowa, in September 2005. The division manager at Jack Links, Karl Paepke, was impressed and arranged for petitioner to meet with Jack Links' marketing director, Peachy Hall, in Minong, Wisconsin, in May 2006. Jack Links ultimately decided not to sponsor Sernett Motorsports because Sernett Motorsports' demographics did not correspond with Jack Links' target demographics at the time. Petitioner did not testify regarding the terms of the proposed Jack Links sponsorship. [*25] We note that even if petitioner had secured a three-year sponsorship along the lines of the unsuccessful Tires Plus proposal for the years in issue, Sernett Motorsports would still have lost money. There is no credible evidence in the record that any of petitioner's other proposals would have brought Sernett Motorsports close to returning a profit. Accordingly, we find that there was little or no likelihood that Sernett Motorsports would earn significantly more sponsorship money than it earned during the years in issue.
Because there is no credible evidence that the substantial losses sustained by Sernett Motorsports were likely to be offset by greater amounts of prize money and sponsorship income during the years in issue, this factor favors respondent.
8. Petitioner's Financial Status
The fact that a taxpayer does not have substantial income or capital from sources other than the activity in question may indicate that the activity is engaged in for profit. See sec. 1.183-2(b)(8), Income Tax Regs. Substantial income from sources other than the activity (especially if the losses from the activity would generate substantial tax benefits) may indicate a lack of profit motive, particularly where elements of personal pleasure or recreation are involved. See id.
Petitioner contends that his success selling telecommunications equipment for NACR depends on his involvement with Sernett Motorsports and sprint car [*26] racing. Respondent contends that petitioner's financial status indicates that he did not operate Sernett Motorsports with a profit motive because he received significant compensation from his employment with NACR during the years in issue and Sernett Motorsports' losses generated large tax savings.
During the years in issue, petitioner earned a significant income as a fully commissioned salesperson for NACR. The losses petitioner incurred from operating Sernett Motorsports provided substantial tax benefits. And, as we findinfra pp. 26-27, petitioner enjoyed racing. Accordingly, this factor favors respondent.
9. Elements of Personal Pleasure or Recreation The existence of personal pleasure or recreation relating to an activity may indicate the absence of a profit objective. See sec. 1.183-2(b)(9), Income Tax Regs. However, an activity is not treated as an activity not engaged in for profit merely because the activity may have recreational or pleasurable elements. Id.
Petitioner contends that he no longer enjoys racing as he once did and that he raced solely for profit during the years in issue. Respondent contends that the record shows that petitioner's lifelong involvement in sprint car racing is motivated, not by a desire to make a profit, but by his love of the sport. [*27] Petitioner testified that maintaining his cars has become a chore and that “the thrill is basically gone”. Petitioner further testified that he continues racing because “it makes me money”. We do not find petitioner's self-serving, uncorroborated testimony to be credible. See Tokarski v. Commissioner, 87 T.C. 74, 77 (1986). Accordingly, this factor favors respondent.
Of the nine factors listed in section 1.183-2(b), Income Tax Regs., four favor respondent, two favor petitioner, and three are neutral. Because Sernett Motorsports was a mature activity during the years in issue, we place particular emphasis in our analysis on its history of significant, sustained losses and on petitioner's inability to reduce Sernett Motorsports' expenses or increase its income. See Golanty v. Commissioner, 72 T.C. at 427 (history of sustained losses is persuasive evidence of activity not entered into with profit motive). After considering the factors, and the facts and circumstances of this case, we conclude that petitioner did not have an actual, honest profit objective in operating Sernett Motorsports during the years in issue. Accordingly, petitioner's deductions for expenses incurred with respect to Sernett Motorsports are subject to the limitations of section 183. [*28] We have considered the parties' remaining arguments, and to the extent not discussed above, conclude those arguments are irrelevant, moot, or without merit.
To reflect the foregoing and respondent's concession,
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