CAN MORE THAN ONE BUSINESS MAKE YOUR HOBBY PROFITABLE?
Internal Revenue Code §183 disallows losses taken regarding any alleged business where there is not a profit motive. If a transaction is not being engaged in for profit, the Internal Revenue Service will disallow all losses related to such activity. The service provides various safe harbors, such as showing a profit three out of five years or five out of seven years. This will establish a presumption that a hobby is not present, but an actual business is. What happens when you run more than one trade or business that are related and one activity creates a loss while others create a profit.
CAN YOU COMBINE THE ACTIVITIES TO ALLEGE YOU HAVE A TOTAL OVERALL GAIN, OR ARE YOU SUBJECT TO THE LOSS RULES ?
The Internal Revenue Service generally alleges that every activity should be viewed as a separate transaction. Two recent cases discuss when you can versus when you cannot combine your activities. In Trilby Pederson vs. Commissioner, 1994 TCM 555, the taxpayer had arguably two separate trades or businesses. In one business she prepared tax returns and in another activity she bred, sold and raised endurance horses. The taxpayer alleged that she intended to in part and parcel of specializing her tax business, to the horse community and was attempting to engage clients by engaging in horse racing activity. Therefore, she argued, the horse racing activities should be combined with her tax return business as a single entity. As a single entity, she argued, she could combine her losses from her horse racing activity to decrease her gains from her tax preparation activity.
The IRS argued that there is no evidence linking the two businesses together. That the contacts she had in the endurance horse business were not also clients in her tax business. The taxpayer’s books and records were not traceable to a specific activity, and he did not obtain any expert advice on how to make her horse business profitable. She did consult with experts on feeding, care and grooming of the horses, but not regarding profitability. Therefore, the IRS alleged, and the court agreed, that no profit motive was present in her horse racing activity and the businesses could not be combined. The taxpayer’s losses were disallowed and substantial income tax was due on her tax return preparation business.
A contrary conclusion was reached In re Wilhelm, 74 AFTR 2d 94-5421, Ms. Wilhelm was the sole shareholder and incorporator of a farming and horse breeding sub-chapter “S” corporation. Prior to the incorporation, Ms. Wilhelm had lived on a farm most of her life and had, in fact, purchased the farm from her family. During her ownership in one instance, one of her heifers had run away and taken up with a bull. A neighbor that had helped Ms. Wilhelm get the heifer back, was gored by the bull, and later sought to recover damages from the taxpayer. After Ms. Wilhelm had settled with her neighbor, she discussed with her accountants and her attorney how she could protect herself from liability. The professionals recommended and, subsequently, did incorporate Ms. Wilhelm’s business.
The corporate structure was to take the majority of the assets, animals, equipment, etc., that were used in the farming business, and lease them back to the farm. The lease was structured so that the exact same amount of expenses that were due and owing on the equipment, would be billed to the farm and paid to the corporation. Since the exact same amount of expenses were paid to the corporation, there could never be any profit. In a perfect, timely payment scenario, a breakeven would be achieved. The IRS, therefore, alleged that no deductions should be allowed for the “S” corporation because there was no profit motive. It was plainly conceded that the business at issue could never make a profit.
The taxpayer argued that the farm, plus the “S” corporation should be combined into one, single business activity. Even though the farm and the “S” corporation together did not make a profit, it was conceded that since this was the taxpayer’s sole, major source of income, that it was intended to operate at a profit. It was not due to the taxpayer’s hard work and effort that the farming business did not make a profit. If combined in a single activity, there could be no argument that it was not an activity entered into for profit, even though no profit was made.
The Bankruptcy Court, which was hearing Wilhelm analyzed §183 of the Internal Revenue Code. The court discussed that §183 was designed to eliminate deductions for wealthy taxpayers engaging in side businesses. The purpose of the hobby loss deduction rules the court expounded was not to penalize taxpayers and institute a punitive section. Therefore, the court combined the “S” corporation and the farm into one single activity and ruled that the one activity was entered into to produce a profit. Therefore, the taxpayer’s deductions for the “S” corporation were allowed. In order to argue the single economic activity theory to avoid the hobby loss rules, a taxpayer had better have some closely related business to their main activity. Mere allegations of some theoretical linkup between the two, usually will not fly in the court.
Remember, hobby losses result in lack of deduction where the transaction, entered into for profit, even if you do not make one, does get you deductions.
COLOMBIK’S LATE BREAKING TAX TIPS
More tax cases are being decided that hold divorce settlements do not always comply with tax law. In Perry vs. Commissioner, 1995 TCM 247, a couple in process of divorce agreed that the husband would vacate the premise, and the wife would stay within such residence until it could be sold. When the house was sold the parties would equally share the proceeds.
The husband moved out of the home and the home was put up for sale. In accordance with IRC §1034, rollover and nonrecognition of gain for sale or exchange of residence, the husband purchased a new residence within the appropriate time period, and reported his gain as being rolled over into a replacement home. The IRS alleged that the husband was not allowed to roll his gain over, as §1034 requires and restricts the nonrecognition of gain solely to a principal residence that is sold and a new, principal residence is purchased within specific time limits. Since the husband was not living in the home when it was sold, it was not his primary residence. Therefore, he was not entitled to nonrecognition treatment. Remember, getting a tax lawyer involved in divorce cases can eliminate some of the unexpected tax issues involved in divorce.
In Shoeffer vs. Commissioner, 1994 TCM 444, a wife advanced funds to her husband’s business to cover the its flow needs. As the loans were made to her husband’s company, the wife did not document the loans with a written note, a repayment schedule, or any other type of written evidence. Subsequently, the business repaid the loans to the spouse. The IRS alleged, however, the repayments were not repayments of notes, but instead were taxable dividends. The court held that since the wife owned no interest in the business, the distributions could not have been taxable dividends. They did, however, discuss in detail, that the lack of documentation on an interest-family loan, does invite strict scrutiny from the Internal Revenue Service. If you document transactions, particularly intra-family transactions, you can protect yourself from IRS scrutiny.
ESTATE TAX DISCOUNT ON CERTIFICATES OF DEPOSIT
In Estate of Helen Ward DeWitt vs. Commissioner, 1994 TCM 550, Mrs. DeWitt placed $250,000.00 in interest-bearing certificates. The money was devised to her son. At death, relative to her estate tax return, the certificates were valued at a discount. The estate alleged that due to the interest and time period, the interest-bearing certificates should only valued at their market value, $187,000.00. The Internal Revenue Service, however, valued the certificates at their face value, $250,000.00. The court agreed with the estate that an estate tax return requires taxation upon value of all property contained within a decedent’s estate. As the value of the certificates was $187,000.00, not their face value, due to the interest rate and term, the lower value, $187,000.00, was the value for estate tax purposes. Therefore, the taxable estate was reduced by the difference between the face value, $250,000.00, and the market value, $187,000.00. A $63,000.00 reduction, reduced the amount of estate taxes due.
SMART MOVE BY INVESTOR
Who said aggressive tax planning is done ? The tax lawyer in Richard Hansen Land, Inc. vs. Commissioner, 1993 TCM 248 has a smart move for his client. In Hansen Land, Inc., Mr. Hansen decided to purchase a parcel of land. Instead of purchasing it personally, Mr. Hansen wanted his corporation, Richard Hansen Land, Inc., to depreciate a share of it, but he, individually, would like to own it. Therefore, the tax lawyer structured a transaction whereby the corporation bought solely a thirty-year right to use the property, while Mr. Hansen personally bought the remainder interest. Since the right to use the property was at a fixed price, a limited term, thirty years, the company depreciated its investment over the thirty-year period. The IRS objected alleging the structure was designed solely to create income tax deductions. Therefore, the IRS alleged this should be recharacterized and the deductions disallowed. The Tax Court agreed with the taxpayer !!! Pursuant to the court it is perfectly legal to structure the transaction to minimize income tax and maximize tax benefits. Since title was actually recorded and the interest segregated, there was a split in ownership and the company could take the deductions.
An interesting way to aggressively structure a transaction and it was upheld by the courts.
Richard M. Colombik, JD, CPA, is an award-winning attorney and CPA with a doctorate in jurisprudence with distinction and was formerly on the tax staff of one of the world’s wealthiest families.
Mr. Colombik has also been a tax manager at a Big Four accounting firm, the State Bar’s liaison to the Internal Revenue Service (IRS), vice president of the American Association of Attorney-CPAs, and vice chairman of the American Bar Association’s Tax Section of the General Practice Council, as well as the past chair of the Illinois State Bar Association’s Federal Tax Committee. Mr. Colombik has also served on the liaison committee to the Washington, DC, National Office of the IRS. Mr. Colombik is also a member of the Asset Protection Committee, American Bar Association, and a member of its captive insurance subcommittee.
Mr. Colombik has appeared on numerous television shows, hosted a weekly radio show on tax and business planning, and authored more than 100 articles on income taxation, asset protection planning, IRS defense, and estate planning. He has also instructed more than 100 seminars to professional groups, business groups, bar associations, CPA societies, and insurance groups. This is in addition to authoring a published work on business entity structures offered by the Illinois Institute of Continuing Legal Education, as well as writing a chapter for The Estate Planning Short Course and Asset Protection Planning.