General Practice, Solo & Small Firm DivisionMagazine
Table of Contents
Tax Treatment of Leisure Accoutrements
BY KEITH BUTCHER
Keith Butcher is an associate in the Taxation and Employee Benefits Group of Moore & Van Allen, PLLC, in Charlotte, North Carolina.
Horses and Mercedes and Vacation Homes, Oh My! As individuals accumulate wealth and their businesses prosper, they expand their personal interests and activities.
Clients may call to ask whether they can deduct the expenses of their horse breeding, car racing, or yachting activities. Clients wonder if they can upgrade their company car from a Chevy Lumina to a Mercedes Benz. Your client may have just bought her dream vacation home in Jamaica and wants to know about the pros and cons of renting it for a portion of the year. But what kinds of tax issues arise from these activities?
Hobby v. Business Activity
Clients with a few extra dollars have a tendency to engage in luxury activities outside of their occupation. These activities can involve a substantial investment of time and money. At some point, individuals become so involved in their activities, or the economic circumstances become favorable enough, that they decide the activities have evolved from a personal hobby into a business. What are the tax implications?
For purposes of income tax treatment, the Internal Revenue Code (I.R.C.) makes a distinction between a hobby and a business.1 Expenses incurred engaging in hobby activities can only be deducted to the extent that the activity produces income.2 In contrast, business expenses are fully deductible regardless of whether the income earned during the year exceeds the losses.3
Take, for example, a taxpayer who raises aardvarks for sale and distribution. The taxpayer incurs $100,000 in expenses in 1998 and receives $1,000 from sales (income) in 1998. If the aardvark breeding activity is a hobby, the taxpayer would deduct $1,000 of expenses against the $1,000 income, resulting in no income or loss. The remaining $99,000 in expenses will be forever lost as a deduction.
However, if the aardvark breeding activity is a business, the taxpayer will deduct the $100,000 of expenses against the $1,000 of income, resulting in a $99,000 ordinary business loss, which can be used to shelter other income (perhaps salary). If the $99,000 “business loss” cannot be used in 1998, it can be carried back two years or carried forward 20 years and applied against any taxable income in those years. However, the $99,000 “hobby loss” produces no benefit and simply disappears.4
So, when does this hobby versus business issue arise? The more common situation involves a taxpayer who has a healthy salary or income from her regular occupation, but who also has an activity that she carries on outside the occupation. Many of the cases concerning this issue deal with doctors or other professionals engaged in activities ranging from horse breeding to mud racing.
For example, consider the case of Doctor X, who calls you on Monday morning ecstatic because he has had a revelation. In a dream the night before, it was revealed to him that his ultimate goal in life is to raise horses. He has called you for guidance in starting his horse ranch. Doctor X has a substantial income of several hundred thousand dollars a year and will carry on the horse breeding activity on the side. After a brief discussion, he discloses to you that he anticipates large losses in the initial years, but is fully confident that his horse ranch will be a huge success, and eventually he will be the business leader of a horse empire. Oh, and by the way, he wonders if he can deduct the initial loss against his salary from his medical practice.
The point to drive home to the client is that there is a line a taxpayer crosses when transitioning from a hobby to operating a business with a “profit motive.” That line represents both a state of mind as well as a commitment to the success of the activity. If the question arises, the taxpayer will have to persuade the IRS that the taxpayer has crossed that line and is committed to operating a business for profit.
What determines whether Doctor X has a profit motive? Like most legal questions, there is no simple answer; it depends on the facts and circumstances. The regulations pertaining to the hobby versus business loss rules list several criteria that courts use to indicate an activity is a business:
• Professional manner in which the taxpayer carries out the activity. It certainly helps when taxpayers keep a separate bank account, maintain accurate and timely accounting books, and conduct their activities in a businesslike manner.5
• The expertise of the taxpayer or her advisors. The courts have found it persuasive when taxpayers are well-educated in the activity or contract/hire qualified experts.6
• Time and effort expended in the activity. Someone must spend time on the activity, either the taxpayer or qualified employees. The courts have found it persuasive where the activity is particularly unpleasant.7
• Expectation that assets used in the activity will appreciate. If the property used to carry on the activity can be expected to appreciate, the taxpayer may be able to persuade the court that, although his activities currently produce losses, the long-term appreciation will offset these initial losses.8
• The past success of the taxpayer in making a profit at similar activities. If the taxpayer has sold a similar profitable business and is starting a new venture, this fact would be persuasive.9
• The history of losses and income for the activity. If the taxpayer’s activity had been profitable in prior years but is currently in a downturn cycle, a profit motive could be persuasively argued. However, courts sometimes use this criterion to fashion a feasibility requirement—not only must a taxpayer exhibit a profit motive, a reasonable probability of success is also required.10
• Degree of loss compared to investment. The courts have found it persuasive when a taxpayer’s losses have been relatively small, the activity has produced income or has a substantial profit potential (albeit speculative at best), and the investor is subject to substantial economic risk.11
• Financial status of the taxpayer. If the taxpayer is receiving a substantial tax benefit from the activity, the IRS is certain to take notice. However, it logically follows that if the taxpayer did not receive a tax benefit, why would the IRS care? Basically, this criterion highlights those taxpayers who have a substantial salary and carry on the activity on the side (as in Doctor X’s case).12
• Elements of personal pleasure or recreation. Although this criterion may be considered contrary to the “American Way,” the courts find it persuasive (that an activity is a hobby) when a taxpayer enjoys the activity that produces the loss. Likewise, the courts find it persuasive (that an activity is a business) where the activity in question is particularly repulsive or physically arduous.13
As suggested above, no single criterion is dispositive. Instead, all facts and circumstances must be analyzed in light of the criteria to determine the decision.14
In practice, it is useful to bifurcate these criteria into controllable and noncontrollable categories. Certain criteria are within the total control of the taxpayer. The lawyer can assist the taxpayer who comes to her initially (e.g., Doctor X) by helping the client to organize the business and satisfy those criteria that are controllable. Prompt the taxpayer to open a separate bank account and to avoid mixing funds. Advise the taxpayer to keep timely books that are updated more regularly than every Decem-ber 31. Alert the client of the need to invest a substantial commitment of time and effort. Finally, urge the taxpayer to formally educate himself through clinics or similar types of schooling.
The remaining criteria (i.e., the noncontrollable criteria) cannot be so easily fulfilled, as they deal with either the results of the activity or the taxpayer’s individual position regarding the activity. Although a lawyer can discuss the probability of success of the activity and the effect it has on the analysis, generally nullifying the client’s enthusiasm is a difficult task. Likewise, it may be unwise and will seldom be successful to counsel the taxpayer to quit his primary occupation to create substantial economic risk. Finally, it is hard to persuade your client to find an activity that is unpleasant, as a client’s personal interests influence these activities.
Evidently there is no simple answer to Doctor X’s inquiry. However, I once heard it explained that these rules can be summarized into the “Duck” rule: If it walks like a duck, quacks like a duck and swims like a duck...it probably is a duck. Similarly, if the activity looks like a business, acts like a business, and is occasionally profitable like a business...it probably is a business.
Once the taxpayer has satisfied the profit motive requirements and is conducting the activity as a business, the next question is what she can deduct. Taxpayer-clients will amaze you with ideas that they find completely reasonable and, notwithstanding the I.R.C., make pretty good sense to you as their lawyer. I once had a frank discussion with a client over the deductibility of groceries. The client was firmly convinced his body was a “revenue producing” piece of equipment, and therefore the expense of keeping his body running should surely be deductible as a business expense. Regardless of the basic common sense underlying this argument, we decided that taking a business expense deduction for groceries was a little too aggressive. While few tax discussions lead to such a clear-cut answer, many can be addressed by some general guidelines or basic common sense.
The federal tax code allows a deduction for ordinary and necessary business expenses relating to the taxpayer’s trade or business.15 It is imperative for the practitioner to keep in mind that what is ordinary and, more specifically, necessary to the taxpayer may not be ordinary and necessary to the IRS. Courts have found, encompassed within the ordinary and necessary rule, the requirement that the expense be reasonable.16 Reasonable is, again, a question of facts and circumstances. Courts have upheld chauffeur-driven limousines for investment advisors, but denied Rolls Royces for doctors.17 The central question is whether the expense in question directly relates to the ultimate goal of making a profit.
When Doctor X comes to you and wants to know whether he can deduct a $165,000 Rolls Royce because he firmly believes that the market for horse owners is among society’s elite and the Rolls will aid in sales, you will have to supply some type of answer. However, do not be too quick to eliminate deductible expenses before completing a thorough analysis of how the expense aids the business. Due to the unique needs of each business, what is ordinary and necessary may surprise you.
The entertainment industry provides a good example of the broad spectrum of deductible expenses. The Journal of Taxation recently published some facts from a Tax Court petition filed by Stevie Nicks (of Fleetwood Mac fame).18 The IRS disallowed some $268,987 in business expenses that Ms. Nicks had reported on her 1991 individual tax return.19 The items in question consisted of: $60,160 for a home office, $12,495 for makeup and hairstyling, $43,291 for professional clothing and maintenance, $119,291 for a personal manager (as opposed to her business manager), and $33,750 in video costs.20
Although these amounts would be unusual for the average individual, they must be analyzed in the context of the business. If you were Ms. Nicks’ advocate, could you not make a plausible argument that these items are ordinary and necessary for her to maintain her public persona, and therefore were paid in connection with attempting to make a profit in her chosen field? The appeal is still pending, but it will be interesting to see if Ms. Nicks prevails.
Inevitably, clients inquire into the tax ramifications of vacation homes. They hear about friends or acquaintances who are sheltering vast amounts of taxable income while enjoying a house on the beach. While vacation homes can be useful for both tax savings and personal leisure, they do not create a “tax holiday.”
To start, it may be useful to outline the general advantages of rental property. Basically, the owner of rental property has four opportunities to gain an economic benefit from the property. First, over a period of time, hopefully, the property will appreciate in value. Second, if properly planned, the rent received can exceed the monthly expense and produce a positive cash flow. Third, when rented, a third party is paying off your mortgage and building your equity. Finally, through depreciation and other deductions, the property can generate losses that can produce tax benefits. This discussion will focus on the last of these economic benefits, the tax benefit.
The method of achieving a tax benefit is fairly simple. The goal is to offset other income, such as salary, by producing a tax loss. However, the mechanics underlying the tax treatment of vacation homes are complex and involve the interplay of several federal tax code sections.21 For our purposes, this discussion will simply touch upon the major tax characteristics of the vacation home.
The degree of personal use prompts the tax treatment of a vacation home.22 The treatment of a vacation home can be separated into four distinct classifications:
1. Free Ride—vacation homes that are rented less than 15 days of the year.
2. Primary Personal—vacation homes that are rented more than 15 days during the year, and the taxpayer’s personal use exceeds 14 days or 10 percent of the rented days.
3. Primary Rental—vacation homes that are rented more than 15 days during the year, and the taxpayer’s personal use does not exceed 14 days or 10 percent of the rented days, whichever is less.
4. Rental—vacation homes that are rented more than 15 days of the year, and the taxpayer does not enjoy any personal use of the residence.
For the taxpayer who simply wants to pick up a couple of extra dollars by renting her home for a couple of days, the Free Ride is perfect. The federal tax code allows a taxpayer to exclude the income derived from the rental of her home if rented 15 days or less during the tax year.23 Consistent with this, the federal tax code does not allow the taxpayer to take advantage of expenses incurred in the production of this rental income.24 However, the taxpayer does not lose any of her interest or tax expenses that she may personally take for the home.25
The Free Ride can be of great benefit to the taxpayer. During the Olympic games in Atlanta, an acquaintance rented his home to a team of gymnasts. The rental price was considerably above the market rent and the individual limited the team’s stay to 14 days and thus enjoyed a healthy Free Ride. The team originally wanted to stay for 21 days; however, after a discussion with his tax advisor, this acquaintance spoke with a neighbor—they split the team’s stay between their two homes and each of them took their families on a much-needed vacation. The moral of the story is that preplanning is essential to effective tax management. Many times the client calls after he gets the tax bill and there is little to nothing lawyers can do to aid him.
The Primary Personal classification deals with a vacation home rented more than 15 days of the year and used by the taxpayers more than the lesser of 14 days or 10 percent of the total rented days for the year.26 Transient retirees are good examples of owners of this type of vacation home. They generally reside in one area for half the year and then move south for the winter. If they were to rent their home/condo for six months of the year and then live in it for the other six months, they would fall into this category simply because they exceeded the 14 days of personal use.
The following example illustrates the 10 percent rule. Couple A rents their condo out for four months or roughly 120 days during the year. In addition, Couple A personally uses the condo for 13 days of the year. Their personal use is more than 10 percent of the total rented days for the year (120 x 10 percent = 12 days) and thus, notwithstanding the fact that they did not use it more than 14 days during the year, they did exceed the 10 percent rule.
Why is this so important? The simple answer is that if you are a Primary Personal vacation homeowner and your home/condo loses money for tax purposes, you do not get to offset your other income with the tax losses. Similar to the Hobby Loss rules above, the Primary Personal vacation homeowner can only use expenses up to the amount of rental income he has produced for the year.27 However, unlike the Hobby Loss rules, the excess expenses carry forward to future years in anticipation of a future profitable year.28
The final aspect of the Primary Personal taxpayer is that he must apportion his expenses.29 This means the taxpayer must divide his expenses during the year between his personal and rental use. Those expenses allocated to personal use are lost. A simple example may help digest this rule. If the Primary Personal taxpayer rents his condo six months of the year and uses it six months of the year, basically all of the assorted expenses (depreciation, utilities, fees, etc.) would be cut in half before being applied to the income produced by the condo. Although this is true for most expenses, those expenses allowed as an itemized deduction on his personal tax return (qualified personal residence interest, etc.) are not lost, but simply half is used against condo income and the other half is recorded as an itemized deduction.
The Primary Rental classification is essentially the opposite of the Primary Personal classification in that the taxpayer rents the vacation home more than 15 days of the year and her personal use does not exceed 14 days or 10 percent of the rented days of the year.30 The critical result of this classification is that, subject to certain passive activity rules, if the taxpayer reports a tax loss for the year, she can use the loss to offset other income such as salary.31 In addition, if the taxpayer does not have any income to offset, the loss can be carried over and used against other income in past or future years.32 Keep in mind that even one day of personal use will cause expense allocation as explained above.33
Finally, the Rental classification occurs when the taxpayer rents the vacation home more than 15 days of the year and has no personal use of the residence.34 This classification is identical to the Primary Rental; however, there is no allocation of expenses. CL
126 U.S.C. § 183(a).
226 U.S.C. § 183(b).
326 U.S.C. § 162.
426 U.S.C. § 172(b).
5Treas. Reg. §1.183-2(b)(1).
6Treas. Reg. §1.183-2(b)(2).
7Treas. Reg. §1.183-2(b)(3).
8Treas. Reg. §1.183-2(b)(4).
9Treas. Reg. §1.183-2(b)(5).
10Treas. Reg. §1.183-2(b)(6).
11Treas. Reg. §1.183-2(b)(7).
12Treas. Reg. §1.183-2(b)(8).
13Treas. Reg. §1.183-2(b)(9).
14Treas. Reg. §1.183-2(b).
1526 U.S.C. § 162(a).
16Commr. v. Lincoln Electric Co., 176 F.2d 815 (6th Cir. 1949).
17Denison v. Commr., 36 TCM 1759 (1977); Connelly v. Commr., 68 TCM 614 (1994).
18Ordinary and Necessary Business Expenses for Entertainers: What’s Reasonable?, 87 J. Tax’n 63 (July 1997).
19Ordinary and Necessary Business Expenses for Entertainers: What’s Reasonable?, 87 J. Tax’n 63 (July 1997).
20Ordinary and Necessary Business Expenses for Entertainers: What’s Reasonable?, 87 J. Tax’n 63 (July 1997).
2126 U.S.C. § 280A; 26 U.S.C. § 469; 26 U.S.C. § 212; 26 U.S.C. § 162; 26 U.S.C. § 61...to name a few.
2226 U.S.C. § 280A.
2326 U.S.C. § 280A(g)(2).
2426 U.S.C. § 280A(g)(1).
2526 U.S.C. § 280A(b).
2626 U.S.C. § 280A(d)(1).
2726 U.S.C. § 280A(c)(5)(A).
2826 U.S.C. § 280A(c)(5)(B).
2926 U.S.C. § 280A(e).
3026 U.S.C. § 280A(d)(1).
3126 U.S.C. § 280A(c)(5).
3226 U.S.C. § 172(b).
3326 U.S.C. § 280A(e).
3426 U.S.C. § 280A.