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.
