Gambling As A Trade Or Business

 

The question came up recently:

How does one convince the IRS that they are a professional gambler?

The answer: it is tough. But not impossible. Here is a quote from a landmark case on the topic:

If one’s gambling activity is pursued full time, in good faith, and with regularity, to the production of income for a livelihood, and is not a mere hobby, it is a trade or business.” (Groetzinger)

First, one must establish that the gambling activity is an actual trade or business.  

Believe or not, the term “trade or business” is not precisely defined in the tax Code. This point drew attention when the Tax Cuts and Jobs Act of 2017 (TCJA) introduced the qualified business deduction for – you guessed it – a trade or business. Congress was stacking yet another Code section on top of one that remained undefined.

Court cases have defined a trade or business an activity conducted with the motive of making a profit and conducted with continuity and regularity.

That doesn’t really move the needle for me.

For example, I play fantasy football with the intention of winning the league. Does that mean that I have the requisite “profit motive?” I suppose one could reply that - even if there is a profit motive - there is no continuity or regularity as the league is not conducted year-round.

To which I would respond that it cannot be conducted year-round as the NFL is not played year-round. Compare it to a ski slope – which can only do business during the winter. There is no need for a ski slope during the summer. The slope does business during its natural business season, which is the best it can do. My fantasy football league does the same.

Perhaps you would switch arguments and say that playing in one league is not sufficient. Perhaps if I played in XX leagues, I could then argue that I was a fantasy football professional.

OK, IRS, what then is the number XX?

The tax nerds will recognize the IRS using that argument against stock traders to deny trade or business status. Unless your name rhymes with “Boldman Tacks,” the IRS is virtually predestined to deny you trade or business status. You trade 500 times a year? Not enough, says the IRS; maybe if you traded 1,000 times. The next guy trades 1,000 times. Not enough, says the IRS. Did we say 1,000?  We misspoke; we meant 2,000.

So the courts have gone to the Code section and cases for hobby losses. You may remember those: hobby losses are activities for which people try to deduct losses, arguing that they are in fact true-blue, pinky-swear, profit-seeking trades or businesses.

You want an example? I’ll give you one from Galactic Command: a wealthy person’s daughter is interested in horses and dressage. Mom and dad cannot refuse. At the end of the year, I am pulled into the daughter’s dressage activity because … well, you know why.

Here are additional factors to consider under the (Section 183) hobby loss rules:

1.  The activity is conducted in a business-like manner.
2.  The taxpayer’s expertise
3.  The taxpayer’s time and effort
4.  The expectation that any assets used in the activity will appreciate in value.
5.  The taxpayer’s history of success in other activities
6.  The taxpayer’s history of profitability
7.  The taxpayer’s financial status
8.  The presence of personal pleasure or recreation

I suspect factors (7) and (8) would pretty much shut down that dressage activity.

Let’s look at the Mercier case.

The Merciers lived in Nevada. During 2019 Mrs Mercier was an accountant at a charter school and Mr Mercier operated an appliance repair business. They played video poker almost exclusively, of which they had extensive knowledge. They gambled solely on days when they could earn extra players card points or receive some other advantage. They considered themselves professional gamblers.

Do you think they are?

I see (3), (7) and (8) as immediate concerns.

The Court never got past (1):

We find that although Petitioners are serious about gambling, they were not professional gamblers. Petitioners are both sophisticated in that they are an accountant and a previous business owner. Petitioner wife acknowledged that as an accountant, she would advise a taxpayer operating a business to keep records. Petitioner husband acknowledged that for his appliance repair business, he did keep records.”

COMMENT: In case you were wondering about the sentence structure, this was a bench opinion. The judge made a verbal rather than written decision.

Petitioners did not personally keep track of their gambling activity in 2019 choosing, instead, to rely on third-party information from casinos, even though they further acknowledged that the casino record may be incomplete, as only jackpot winnings, not smaller winnings, are reported. Petitioners also did not keep a separate bank account to manage gambling winnings and expenses, but used their personal account, which is further evidence of the casual nature of their gambling.”

My thoughts? The Merciers were not going to win. It was just a matter of where the Court was going to press on the hobby-loss checklist of factors. We have learned something, though. If you are arguing trade or business, you should – at a bare minimum – open a business account and have some kind of accounting system in place.  

Our case this time was Mercier v Commissioner, Tax Court docket number 7499-22S, June 6, 2023.

A Good Hire Can Help Prove You Are Serious About A Business

If you have gig, there is a presumption in the Code that it will be profitable.

Mind you, it may not be profitable every year. Not even Fortune 100 companies are profitable every year.  Still, the gig is expected to be profitable on a cumulative basis.

Seems obvious. Why are we talking about this?

Say that you have an internet-based business. The business itself is profitable, but you are spending so much on research, hardware, and infrastructure that - overall – the business shows a loss. You know better. You know that, soon enough, the business will turn the corner, those expenses will taper off, and you will make a fortune.

Or maybe you are funding a promising teenage boxer. Everyone sees the potential for the next Mike Tyson. You see it too.

What if your business is sitting on land that will one day be – if it is not already – absurdly valuable? Even if the business is unprofitable, the sale of the land will eventually trump those losses.

We are talking about hobby losses. You say it is a business. The IRS says it is not. It is one of the trickiest areas in the Code.  

There are several repetitive factors that the IRS looks for, such as:

(1)  You don’t treat it like a business. Little things are a tell, like not having accounting and not pivoting when it seems clear you have a loser.

(2)  You make a ton of money elsewhere, so it is financially insignificant whether that activity ever shows a profit.

(3)  You derive a high degree of personal pleasure from the activity.

Let’s look at a recent hobby loss case.

In 2004 the Wondries bought an 1,100-acre ranch in California. They borrowed at the bank, indicating in the paperwork that they would make money by selling cattle and providing guided hunting expeditions.

Mr. Wondries was a sharp cookie. He had already owned around 23 car dealerships, and he had a track record of turning losing dealerships into profitable ones.

He had no experience in ranching, though, so he hired someone (Mr. Palm) who did. Wondries hired Palm the same day he bought the ranch.

Good thing. Palm was mentoring Wondries on the fly, and they both realized that cattle raising was a no-go. They could not overcome feed prices. They thought about allowing the cattle to graze in the fields and growing their own barley, but a drought soon took away that option.

There was no money there. They sold most of the cattle.

Pivot.

Next was the guided hunting expeditions. The ranch was too small for certain (read: the desirable and profitable) hunts. We haven’t even mentioned insuring a hunting activity.

Bye to hunting.

Pivot again.

Wondries and Palm still thought they could make money by holding the land for investment. Seems that Wondries bought the land at a good price, so there was room to run.

Over three years (2016 to 2017) the ranch lost over $925 grand. You and I would have run for the hills, but Mr. Wondries’ W-2’s for the period totaled over $12 million. He could take a financial hit.

Big W-2. Substantial losses from a gig. Looks like meaningful personal pleasure is involved. The IRS caught scent and went for it.  Hobby loss. No loss deductions for you.

Off to Tax Court they went.

These cases tend to be very fact specific. While there are criteria the courts repetitively consider, that does not mean each court interprets, applies, or weights the criteria in the same manner.

Let’s go over them briefly.

(1)  The way taxpayer conducts the activity

 

The Court saw a business plan, an accounting system, and the hiring of an industry pro.

 

This went in the taxpayers’ favor.

 

(2)  Expertise of taxpayer or advisors

 

Wondries’ expertise was in dealerships, but he recognized that and hired a ranching pro. He also listened to the pro while trying to make the ranch profitable.

 

This went in the taxpayers’ favor.

 

(3)  Time and effort expended by taxpayer

 

The Wondries together spent an average of six days per month at the ranch. It was not much in the scheme of things.

 

To be fair, they had other stuff going on.

 

This still went in the taxpayers’ favor. Why? Because the manager was there full-time, and his time was imputed to the Wondries.

 

(4)  Expectation that assets used in activity will appreciate   

 This went in the taxpayers’ favor.

 

(5)  Taxpayer success in other activities

 

Wondries was a successful businessman.  

 

This went in the taxpayers’ favor.

 

(6)  History of activity income or loss

 

The ranch was a loser.

 

This went against the taxpayers.

 

(7)  The amount of profits compared to losses

 

The concept here is whether there were wee profits against huge losses.

 

This went against the taxpayers.

 

(8)  Taxpayer financial status

 

The Wondries were loaded.

 

This went against the taxpayers.

 

(9)  Elements of personal pleasure in the activity

 

The IRS pounced on this one. A ranch? Does anything say personal pleasure like a ranch?

 

The Court thought otherwise. They noted that the Wondries were working when they were there. They were hiking, biking, or boating when they visited their other properties. This lowers one’s motivation in wanting to visit the ranch.

 

The Court spotted the taxpayers this one.

 

The Tax Court decided the ranching activity was a business and not a hobby.

Not surprisingly, they also noted that:

                  This is a close case.”

What swung it for the Wondries?

Two things stand out to me:

(1)  The Court did not see significant personal pleasure in owning the ranch. In fact, it sounded like any pleasure from showing- off the ranch was more than offset by working every time the Wondries visited.

(2)  Hiring an industry pro to run the place. By my count, the ranch manager swung the Court’s decision in at least three of the above criteria

Hobby loss cases are fickle. What can tax advisors take away from this case?

Hire a pro to run the thing. Give the pro authority. Listen to the pro. Pivot upon that advice.

To say it differently, don’t be this:

Our case this time was Wondries v Commissioner, T.C. Memo 2023-5.

A Model Home As A Business

 

What does a tax CPA do a few days after the filing deadline?

This one is reviewing a 17-page Tax Court case.

Yes, I would rather be watching the new Batman movie. There isn’t much time for such things during busy season. Maybe tomorrow.

Back to the case.

There is a mom and dad and daughter. Mom and dad (the Walters) lived in Georgia. They had launched three successful business in Michigan during the 70s and 80s. They thereafter moved to Georgia to continue their winning streak by developing and owning La-Z-Boy stores.

During the 90s dad invested in and subsequently joined the board of an environmentally oriented Florida company. He followed the environmental field and its technology, obtained certifications and even guest lectured at Western Carolina University.

Daughter received an undergraduate degree in environmental science and then a law degree at a school offering a focus on environmental law.

After finishing law school, daughter informed her parents that she was not interested in the furniture business. Mom and dad sold the La-Z-Boy businesses but kept the real estate in an entity called D&J Properties. They were now landlords to La-Z-Boy stores.

The family decided to pivot D&J by entering the green real estate market.

Through the daughter’s connections, mom and dad became aware of a low-density housing development in North Carolina, emphasizing land conservation and the incorporation of geothermal and solar technologies.

You know this caught dad and daughter’s attention.

They bought a lot. They built a house (Balsam Home). They stuck it in D&J Properties. The house received awards. Life was good.

They received an invitation to participate in a “Fall Festival of Color.” Current and potential property owners would tour Balsam Home, meet with members of the team and attend a panel discussion. Word went out to the media, including the Atlanta Journal-Constitution.

Balsam Home became a model home for the development. Awards and certificates were hung on the walls, pamphlets about green technology were placed on coffee tables. A broker showed Balsam Home when mom and dad were back at their regular residence.

Sometimes the line blurred between model home and “home” home. Mom and dad registered cars at the Balsam Home address, for example, and dad availed himself of a golf membership. On the flip side, the green technology required one to be attentive and hands-on, and mom and dad did most of that work themselves.

Where is the tax issue here?

Balsam Home never showed a profit.

The La-Z-Boy stores did.

The IRS challenged D&J Properties, arguing that Balsam Home was not a business activity conducted for profit and therefore its losses could not offset the rental income from the furniture stores.

This “not engaged in for profit” challenge is more common than you may think. I am thinking of the following from my own recent-enough experience:

·      A mom supporting her musically inclined twin sons

·      A young golfer hoping to go pro

·      A model certain to be discovered

·      A dancer determined she would join a professional company

·      A dressage rider meeting “all the right people” for later success

The common thread is that some activity does not make money, seems likely to never make money but is nonetheless pursued and continued, normally by someone having (or subsidized by someone having) enough other income or wealth to do so. It can be, in other words, a tax write-off.

But then again, someone will be the next Bruno Mars, Scottie Scheffler or Stevie Nicks. Is it a long shot? Sure, but there will be someone.

Not surprisingly, there is a grid of questions that the IRS and courts go through to weigh the decision. It is not quite as easy as having more “yes” than “no” answers, but you get the idea.

Here is a (very) quick recap of the grid:

·      Manner in which taxpayer carried on the activity

·      Taxpayer’s expertise

·      Taxpayer’s advisors’ expertise

·      Time and effort expended by the taxpayer

·      Expectation that activity assets will appreciate in value

·      Success of the taxpayer on carrying on similar activities

·      History of activity income and loss

·      Financial status of the taxpayer

·      Elements of personal pleasure or recreation

Let’s review a few.

·      Seems to me that mom, dad and daughter had a fairly strong background in green technology. The IRS disagreed, arguing “yes this but not that.”  The Court disagreed with the IRS.

·      Turns out that mom and dad put a lot of time into Balsam House, and much of that time was as prosaic as fertilizing, weeding and landscaping. The Court gave them this one.

·      Being real estate, it was assumed that the asset involved would appreciate in value.

o  BTW this argument is often used in long-shot race-horse challenges. Win a Kentucky Derby, for example, and all those losses pale in comparison to the future income.

·      I expected financial status to be a strong challenge by the IRS. Mom and dad owned those La-Z-Boy stores, for example. The Court took pains to point out that they had sold the stores but kept the real estate, so the ongoing income was not comparable. The Court called a push on this factor, which I considered quite generous.

The Court decided that the activity was conducted for profit and that losses could be used to offset income from the furniture stores.

A win for the taxpayers.

Could it have gone differently?

You bet. Court decisions in this area can be … quixotic.  

Our case this time was Walters v Commissioner, T.C. Memo 2022-17.

A Horse Activity And Owning A Horse

Her story has been out there for a while.

I did a quick search and found that she appeared before the Tax Court in 2013. She was back in 2015 and now again in 2019.

Her name is Denise Celeste McMillan (McMillan), and she has to do with horses.

In the tax world, horses have to do with hobby losses.

Let’s take a moment on what that term means.

Let’s say that you take on a side gig. It is arguable how serious you are about the gig, but there is no argument that you are losing money doing it.

And you keep losing money … year after year.

The first thing you or I would ask is: why? The second question would be: how are you affording to do this?

There you have the two issues at the heart of a hobby loss challenge:

(1) Are you running your gig as a business? If the gig is lagging, a business owner would do something: market more effectively, swap-out products offered for sale, move to another location with better traffic, maybe even close the business and try something else.

(2) How can you afford this? Maybe you sold your business for huge bucks and are now following your lifelong dream of collecting every Ukrainian comic title printed from the 1950s through the 1970s. It is not a lucrative business, but it has a loyal following. You can afford to live the dream because of that big-bucks thing.

McMillan definitely loves horses. She started riding at age four and started formal lessons at age nine. She won numerous awards. She started a specialized business, taking difficult horses on consignment. She would retrain them and later sell them at a profit.

Sounds interesting.

She normally kept between one and six horses.

The more the better, methinks.

She went through a difficult stretch (ten years) owning just own horse (Goldrush).  Goldrush had issues and did not compete, show or breed.

Not good.

In 2007 she sent Goldrush to Australia to stand at stud.

That should get the revenues going again, hopefully.

In 2008 and two months after arriving in Australia, Goldrush died.

Wow.

I guess she will have to get another horse or few and restart.

She did not.

What she did however is keep deducting horse-related expenses.

And now we have her third trip to Tax Court.

She says she has a business.

The IRS says she does not.

What do you think?

Here is the Court:

We believe Ms. McMillan when she says that she’s been continuously involved with horses since the 1970s. But her last horse died in 2008, at which point she hadn’t shown or bred in a decade. We therefore find that if her horse activity was ever a trade or business, that trade or business ended before 2010, and in that year she was at most looking at starting anew.”

The Court is being diplomatic here. It is saying that her previous activity had ended, but perhaps another had taken its place.

So the question is: had she started a new activity after the death of Goldrush?

Remember that in tax-speak, an activity requires “regular and continuous” involvement. It does not have to be a 24/7 thing, but it does have to be more than “someday isle” dreamweaving over beers with a friend.

Ms. McMillan’s ‘horse breeding/showing’ business hadn’t actually commenced or resumed by the end of 2010.”        

Guess not. The best she could get would be start-up expenses, to be deducted over time once that business in fact started.

The moral of story seems clear: if you want to say that you are in the horse business, you may want to own a horse.

Captain Eddie’s Firefly

The case starts with:

Edward G Kurdziel is the only man in America licensed to fly a Fairey Firefly. He is also the only man in America who has a Firefly to fly.”

I was immediately hooked.

What is a Fairey Firefly?

The Firefly entered service as a carrier-based fighter for the Royal Navy toward the end of the war (WW II - CTG), and became a specialist in antishipping and antisubmarine warfare.”

Mr Kurdziel – also known as Captain Eddie – explained that the Firefly “was the first British airplane to fly over Japan and Tokyo in 1945 during the [occupation] of Japan.”

In the fall of 1993 Captain Eddie learned that a Firefly was for sale in Australia. He travelled; he consulted with mechanics. The plane had not flown in years, possibly decades.

He borrowed against his house and bought the plane for $200,000. It cost another $60,000 to have it shipped.

The plane is a near-museum piece. What was he going to do with it?

His early plan was to sell rides on the plane. He looked into insurance (can you imagine?). He collaborated with the Royal Australian Navy on a plan to restore the plane.

That took eight years, 45,000 man-hours and as many as 10 full-time workers.

Captain Eddie was a bit of an Anakin Skywalker, designing and crafting many replacement parts himself.

In 2002 he received an “air worthiness certificate” from the FAA. He also got the FAA to license him to fly it. To this day, he is the only person in the country with such a license.

He showed the plane. It won prizes. It landed on 20 or 30 magazine covers.

This being a tax blog, there has to be a tax angle. What you think it was?

Yep, Captain Eddie deducted everything.

Problem: to pull this off, Captain Eddie had to persuade the IRS – and then the Court – that he actually had a business. As opposed to … say … a hobby. A really cool hobby, but a hobby nonetheless. A business has to have the intent – perhaps misplaced but nonetheless sincere – that it will show a profit.

How was this old warbird going to show a profit after the near-herculean effort and cost of restoring it?

Rides? Nah, that was nixed immediately by the authorities. No surprise that the FAA was not too keen with public rides on an antique, near-unflyable-by-today’s-standards airplane.

There were airshow appearances and prizes.

Yes, but the winnings were a pittance against what he spent. No chance of a profit there.

The Firefly crashed in 2012. Captain Eddie is still working on its repair.

The IRS brought out its hobby loss hammer and said “no deduction here.”

Off to Court they went.

Captain Eddie had to show that a sane businessperson would keep putting money into a money pit. Granted, one may do it for love, for respect for history or other reasons, but those reasons are not business reasons.

But it can happen. Take thoroughbred horses, for example. The odds of winning the Derby are miniscule, but the payoff is so great – especially if one can win the Triple Crown – that the activity can still make business sense.

Captain Eddie had an ace in his hand: he could sell the plane for a profit.

Mind you, there are a number of factors the Court could consider, such as:

·      Manner in which the activity is conducted

·      Expertise of taxpayer or advisors

·    Time and effort expended by taxpayer

·      Success on carrying on other similar activities

·      History of income or loss

·      Amount of occasional profits, if any

·      Taxpayer’s financial status 

·      Elements of personal pleasure or recreation 

·      Expectation that assets used in activity will increase in value

Captain Eddie won and lost some of these. For example, he received retirement pay pushing $180K from the Navy and Delta. He could afford an expensive hobby. There was no question about the pleasure he derived from the Firefly. He had a real estate business, but that it was a stretch to argue that it was “similar” to the Firefly.

At trial, Captain Eddie brought in experts who testified the plane was worth between $3.5 and $8 million. That would cover the approximately $1.9 million Captain Eddie had put into it.

The IRS quickly pointed out the plane crashed and had not flown since.

But planes can be repaired….

The Court acknowledged that Captain Eddie could have made money by selling the plane, but then it wondered why he did not sell it years before, when it was winning all those awards. That would likely have been its peak price.

The Court considered all the pieces.

• Initially Captain Eddie had thought of selling rides. The Court was unimpressed. A moment’s research would have told him there was no chance the FAA would allow this.
• A businessperson would respond by revising the business plan. The Court was looking at things titled “Original Plan 1999-2000?,” which did not increase its confidence that Captain Eddie had landed on his feet. 
• He had listed the activity on his personal tax return as “airplane leasing,” The Court was not humored, as nothing had ever been leased. 
• He filed a local property tax exemption for the Firefly, stating that he was not using it for commercial purposes or holding it for sale. 
•  Oh oh
• If he had thought of selling the plane, he waited a long time – 2014 – before obtaining an appraisal. The Firefly was rocking it in the early aughts – many years before 2014. 

It didn’t add up. The Court was bothered by the rides, as that would have taken minimal effort to discover. Why didn’t Captain Eddie entertain offers for the plane? Why would he sign property tax paperwork saying the plane was personal and not commercial-use or held for sale?

The Court said hobby. No loss for Captain Eddie.

A taxpayer can win a hobby loss challenge. It happens quite a bit, actually. The key is that the taxpayer should respond as a businessperson would. If one door shuts the taxpayer must show that he/she went after another open door, always with the objective of making a profit. Maybe it played out, maybe it did not – but the taxpayer tried.

And it helps to be consistent, the one thing Captain Eddie failed to do.

Our case this time is Edward G. Kurdziel, Jr v Commissioner.