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Monday, May 20, 2013
hobby loss case
Tax Court largely denies taxpayers' deductions for aircraft, vineyard & shopping activities Heinbockel, TC Memo 2013-125 The Tax Court has largely denied the deductions claimed by a married couple in association with the husband's airplane chartering business, property that they purportedly intended to turn into a vineyard but didn't, intra-family loan costs, and the wife's personal shopping business. The Court found that the husband's airplane activity wasn't entered into for profit, that their “lending activities” weren't a bona fide trade or business, and that their vineyard costs should be capitalized into the property's basis. The Court further denied many of the personal shopping business costs for inadequate substantiation. Background on hobby loss rules. Under the Code Sec. 183 hobby loss rule, deductions attributable to a “not for profit” activity are allowed only to the extent of income from it, or to the extent deductions are allowable regardless of any profit-seeking motive, whichever is larger. (Code Sec. 183, Reg. § 1.183-1) All facts and circumstances must be considered in the determination of whether a taxpayer has a profit objective under Reg. § 1.183-2(b), which lists nine factors: (1) The manner in which the taxpayer carried on the activity; (2) The expertise of the taxpayer or his advisors; (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 other 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, which are earned; (8) The financial status of the taxpayer; and (9) The presence of personal pleasure or recreation. Background on business deductions. Under Code Sec. 162(a), a taxpayer can deduct all ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business. A trade or business expense is ordinary if it is normal or customary within a particular trade, business, or industry. It is necessary if it is appropriate and helpful for the development of the business. Taxpayers are also required under Code Sec. 6001 to substantiate their claimed deductions. In addition, under Code Sec. 274, heightened substantiation requirements apply to: (1) any traveling expense, including meals and lodging away from home; (2) any item with respect to an activity in the nature of entertainment, amusement, or recreation; (3) any expense for gifts; or (4) the use of “listed property,” such as a passenger automobiles. The taxpayer must substantiate by adequate records or by sufficient evidence corroborating the taxpayer's own statement: (1) the amount of the expense; (2) the time and place of the travel, use of the property, etc.; (3) the business purpose of the expense, and (4) the business relationship to the taxpayer. To do this, a taxpayer must maintain records and documentary evidence that in combination are sufficient to establish each element of an expenditure or use. (Reg. § 1.274-5T(c)(1) and Reg. § 1.274-5T(c)(2) ) Facts. Ed and Lydia Heinbockel are, as described by the Tax Court, “a happy couple possessed by entrepreneurial spirit.” During 2005-2007 (the years at issue), Ed worked full-time running a successful company and Lydia ran a personal shopping business called “Lydia's World.” They claimed many deductions in association with Lydia's World, and they also claimed significant losses during those years from three other activities. “Collective Flight” was Ed's “one-airplane transport company.” Ed was a passionate flyer who purchased a plane in 2004, supposedly for business purposes. However, his loan agreement indicated that it was bought for personal use, and he seldom actually used it for business trips and had no other clients. His reported revenue from Collective Flight was $4,000 in 2005, $30,000 in 2006, and $6,000 in 2007, but the expenses for each year ranged from approximately $45,000 to $100,000. Also in 2004, the Heinbockels bought property in wine country to build a home and establish a vineyard. They hired an architect and purchased a tractor to grade the land, but faced legal opposition from their neighbors and the county. Although they eventually got a permit to establish a vineyard, they never actually planted a single grapevine and sold the property in 2007. They reported losses of $49,000 in 2005, $13,000 for 2006, and $8,000 for 2007. The Heinbockels reported a net loss in 2005 from a “residential rental.” However, they didn't own the property—rather, it was owned by Lydia's brother, to whom Lydia lent money for rehabilitating the property. The property ultimately was abandoned, and Lydia got “drug into” a lawsuit over it and hired attorneys to recover some of the borrowed money. She eventually received a $230,000 award which they reported as an overall $25,784 loss on their 2005 Schedule E. At trial, however, they argued that they had a lending-activity loss of $11,884 that should have been reported on Schedule C. IRS's position. IRS disallowed all of the losses from Collective Flight in 2005 and 2006 because the activity wasn't entered into for profit, then disallowed almost all of the expenses from 2007 because they weren't ordinary and necessary business expenses. At trial, IRS contended that the 2007 Collective Flight disallowance was also based on lack of profit motive, and thus carried the burden of proof on that issue. With regard to the vineyard losses, IRS denied all claimed losses in 2005 and 2006 on the basis that all amounts spent during a farm's preproduction period must be capitalized, and since not a single grape was grown on the property, those amounts should have been added to basis. For 2007, IRS only disallowed the depreciation expense for lack of substantiation and for failure to show that the expense was ordinary and necessary to the business. However, in its pretrial memos, IRS claimed that the 2005 and 2006 losses should also be disallowed for failure to substantiate and because the expenses weren't ordinary and necessary. Then, at trial and in posttrial briefs, IRS's continued to assert contrary positions, including that no active trade or business was carried on and that the expenses start-up costs under Code Sec. 195. Tax Court's conclusions. The Tax Court largely ruled against Heinbockels, as follows: ...No profit motive for aircraft. The Tax Court examined the profit objective factors outlined above and easily concluded that Ed didn't engage in the Collective Flight activity for profit. Thus, the Heinbockels weren't entitled to deductions in excess of income. The Court found it telling that Ed didn't conduct Collective Flight in a businesslike manner, failed to keep complete records, didn't institute changes in an effort to earn a profit, didn't seek guidance from industry experts, didn't devote significant time to the activity, had no previous aircraft-industry-related successes, had significant income from other sources, and derived significant pleasure from flying. ...No lending business. The Court also easily found that the Heinbockels didn't operate a lending business, agreeing with IRS that this was another attempt to deduct personal expenses. The purported “business” consisted of loans to Lydia's brother, and there was no evidence to show that this activity was operated in a businesslike way. There were also complications with the Heinbockels' treatment of attorney fees and other expenses. Ultimately, the Court found that the $230,000 settlement, less the $148,801 loan, left an $81,199 accession to wealth that reflected “the settlement of a claim for lost income” and thus should be categorized as gross income. ...No grape farming business. The Court, after wading through the various and conflicting theories asserted, determined that all of the disallowed expenses should have been deferred under Code Sec. 195's start-up provisions until an active trade or business began. And, since they sold the property without ever beginning business or even planting a single vine, those costs should have been capitalized and added to the basis of the property. ...Lydia's World expenses largely denied. The Tax Court also denied most of the expenses claimed by the Heinbockels in connection with Lydia's personal shopping business. The Court generally agreed that Lydia treated herself as a brand ambassador—constantly promoting her business and maintaining an image consistent with a luxury brand—and that her business and personal activities were at times difficult to distinguish. However, the Court found that her lack of separation combined with her lack of recordkeeping precluded deductions under Code Sec. 274. For example, she claimed mileage deductions, but failed to provide any contemporaneous logs or records. he Heinbockels did a good deal of travel and dining, purportedly for her business, but didn't support any of these expenses as required under Code Sec. 274. However, certain deductions for taxes, licenses, and interest were allowed. ...Penalties upheld. Finally, based on the above, the Tax Court upheld IRS's imposition of a 20% penalty under Code Sec. 6662 for the tax underpayment for each year at issue.