Current status and considerations of hobby losses and their impact on entrepreneurs.

Klett, Taylor S. ; Quarles, Margaret

ABSTRACT

Various legitimate "at risk" entrepreneurial start-up activities-especially family oriented businesses- are subjected to constrictive guidelines established by statute and the courts, possibly discouraging otherwise promising entrepreneurial activities by timid taxpayers not wishing to be aggressive. Conversely, the hobby loss rules act to prevent the expensing of what otherwise would be personal expenses disguised as "valid" business expenses, thereby causing significant losses of revenue to the Treasury. Somewhere between the two extremes are legitimate activities entered into for the purpose of making profits yet are treated with hostility by the service. This paper explores the background and current status of the hobby loss rules and their unexpected impact on the small entrepreneur.

THE ENTREPRENEURIAL SAGA BEGINS

The hobby loss restriction has been a valued part of the IRS armada for many years, restricting attempts by taxpayers to claim expenses (and thus deductions from income) beyond rather meager income derived from the taxpayers' "pet" projects. The logic behind such restrictions is otherwise reasonable: e.g., if the taxpayer does not earn a profit from the activity, some other alternative reasoning behind the activity must exist. Usually it is assumed that the activity is undertaken purely for the taxpayer's pleasure and therefore the taxpayer is attempting to pay for the activity at the government's expense.

Such an audit approach is simple; it doesn't require much effort to handle the situation to disallow such deductions. Unfortunately, this conclusion makes it extremely easy to overlook or ignore other tangible or intangible aspects of the alleged business "effort," particularly when the entrepreneur abandons the activity or is convinced that the Service does not deem the activity to be a viable entity. Of course, some entrepreneurs go on to prove the Service wrong, but many do not continue after an unfavorable audit event.

While this tough approach is understandable from a revenue enhancement viewpoint, it is arguably quite lacking in considerations relevant in the business world and available to entities that, for whatever reason, from the Code's viewpoint, were otherwise "legitimately" established. There has always been a presumption of legitimacy for the more complex the business forms (i.e., the establishment of a corporation or partnership), but even that legitimacy is sometimes challenged.

It is almost automatically assumed that if someone has incorporated or developed a partnership agreement for the business entity, "serious" business reasons must exist for the expenditure of scarce capital. In fact, the Code encourages such expenditures by allowing the amortization of the start up expenses over a sixty month period.

This postulate, however, does not seem to consider that such start up costs are not inconsequential to an individual taxpayer: often the individual naturally wishes to minimize the beginning and ongoing operating costs of the business activity to enhance survival possibilities of the business through the conservation of scarce capital. Further, the prudent taxpayer also wishes to minimize personal exposure to loss of capital if the activity later collapses or becomes unfeasible. While certain theoretical lip service is given to these notions, it appears in reality this risk is often not seriously considered by the Code nor by the Service.

Interestingly, there has been utmost "hostility" to many forms of activity whereby a child and a parent jointly venture into some activity, especially in the areas of music, sports and/or art. These areas, while others certainly exist, provide valuable insights when contrasting presumptions with everyday reality. A hypothetical yet illustrative case might be useful to explore the various ramifications of the matter.

OUR HYPOTHETICAL SITUATION

Assume the taxpayer has a gifted and very talented child in music or dance. Because many such children exist, simple economics precludes outside third-party agencies in fronting funds to cover the costs to develop, produce or market all children who have outstanding potential. Thus, a commonly litigated situation develops: the child's parent becomes the child's agent or business manager and establishes a business activity such as management, consulting, production or some such activity for profit. Unfortunately, the income level is paltry at best in the early years and expenses far exceed revenues. Because the music and/or entertainment business is extremely competitive, success usually comes only after several years of effort.

Thus the tax "rub." A business activity, in general, is expected, per the regulations, to make a profit for at least two out of five years. Suppose then, before the fourth or fifth year of full operations, an audit of the third or fourth year occurs. Of course no profit has yet been earned, even though the business is strengthening. The result of the audit could be catastrophic.

AND SO "OUR TASK" BEGINS-THE PROOF OF A FOR-PROFIT BUSINESS

While we generally view the tax code as designed to reward risk takers, it does not do so here. Interestingly, the Service recognizes that horse racing takes time, and grants additional time to achieve a profit (seven as opposed to five years). Unfortunately, in some businesses, it may take ten or more years to generate a profit--even horse racing!

While sometimes hostile to the so-called hobby business, the courts have been gracious in providing clearer and more articulately defined guidelines than those of the Service. As gratifying as it is to have these clarifications or enhancements, even these precepts arguably fall short and in some cases seem openly hostile to the entrepreneurial spirit.

DEDUCTIBILITY?

The first real "test" is whether the talent manager/agent's expenses can be deducted in the first place. Welch v. Helvering, 54 S. Ct. 8 (1933), teaches an expense is necessary, and accordingly deductible, if a prudent person would incur the same expense and the expense is expected to be appropriate and helpful in the taxpayer's business. In Blackmer v. Commissioner, 70 F2d 255 (1934), the court teaches that a "necessary expense" is one that is appropriate and helpful, rather than necessarily essential to the taxpayer business. Commissioner v. Tellier, 383 US 687 (1966) held that "normal and necessary" means that the expenditure must be normal, usual and customary, as well as appropriate and necessary and helpful to the operation of the business. James M. Green, T.C. Memo 1989-599 held that if the taxpayer is not engaged in profit, no deduction attributable to such activity is allowed as a deduction, and conversely, if truly engaged in for profit, the deduction is allowed. Flint v. Stone Tracy Co., 220 US 107 (1911) defines a 'business' as "that which occupies the time, attention, and labor of men for the purpose of a livelihood or profit." Interestingly, in Holmes v. Commissioner, 83 AFTR 2d 99-298, 184 F3rd 536 (1999), the Tax Court held that "an activity is engaged in for profit if the taxpayer entertained an actual and honest, even though unreasonable or unrealistic, profit objective in engaging in the activity" (emphasis added). Finally, the Tax Court held in Lou Levy, 30 T.C. 1315 (1958) that an artist's agent who invests money in hopes that artist will become a star may deduct the related expenses.

In Valerie Jean Genck v. Commissioner, T.C. Memo 1998-105, the Court allowed the taxpayer's expensing of its rental of recording studio used in production of CDs and blank CD's as supplies as opposed to capitalization of those expenses. In Charles Hutchinson v. Commissioner, 13 BTA 1187 (1928) theatrical clothes as opposed to "everyday" clothes were allowed as deductible. Conversely, the court held that wigs, makeup, skin care, and hair care were not deductible unless proven for business use.

Thus, the business expense must be "normal and necessary" but not "essential" to the taxpayer's business, and the business - that is, an activity intent upon profit--depends upon the finding that an actual, honest, however unreasonable or unrealistic, profit objective was envisioned.

WHOSE INCOME/DEDUCTION?

Another major question raised consistently by the Service is whether the income or deduction is attributable to the parent/agent or to the child/performer? A good working definition of a talent or personal manager was given in Waisbren v. Peppercorn Products, Inc. 41 Cal. App 4th 246, wherein the court noted that a talent/personal manager's primary function is to advertise, counsel, direct and coordinate the artist in the development of his career, including the direction of the artist/client's personal affairs. In Anthony J. Carino, Jr., T.C. Summary Opinion 2002-140, the execution of the personal management agreement by Mr. Carino, the petitioner, and his daughter did not constitute a change in "Mr. Carino's relationship with his daughter from parent to manager for profit." ... "[H]e has no agreement or understanding in place providing him with a percent or interest in any future earnings ..."

In Fritschle v. Commissioner, 79 T.C. 152 (1982) the central issue was whether the income received by the taxpayer and claimed by the Service to belong to her children was actually the taxpayer's income. It was held that payment for work done at home mostly by taxpayer's children was taxable to the taxpayer, as she had sole responsibility for the performance of all work and the children merely assisted. IRC [section]73 was not applicable because the children were not the actual earners of income. The critical factor viewed by the court was the predominate command of the taxpayer over the income, citing Harrison v. Shaffner, 312 US 579 (1941). The court in Johnson v. Commissioner, 78 T.C. 882 (1982) noted that the true earner cannot always be identified by pointing "to the one actually turning the spade or dribbling the ball." Thus, because the true earner cannot always be clearly identified, the issue of who controls the earning of the income is critical. Recall [section]73 normally operates to tax a minor child on income he is deemed, in the tax sense, to have earned. If, on the other hand, there was a finding in Fritschle that it was the services of children that were contracted and that the children were the true earners of the income, [section]73 would then tax the children on the income. For example, a baseball bonus paid to the mother was actually income to the major league baseball player. Allen v. Commissioner, 50 T.C. 466 (1968), aff'd, 401 F. 2d 398 (3rd Cir. 1969). Although the contract of employment was made directly by the parent and the parent receives the compensation for the services, the income would be considered taxable to the child because it was earned by the child. (H. Rept. 1365, 1944 CB 821). In reality, this language merely recognizes parents as the contracting parties when, due to legal capacity, minor children cannot enter into valid contracts. Critically, it must still be shown that the services of the child were being contracted for and--more importantly--that the children controlled the earning of the income. (Fritschle).

In Cecil Randolph Hundley, 48 T.C. 339 (1967), the business expense deduction was allowed for the parent/agent of a pro baseball player. The agreement between the two was based on the time spent in training and representing the player/child and it was clear that the ultimate receipt of payment was uncertain and undeterminable. However, payments were made to parent/agent after services were rendered but while the taxpayer parent was still engaged in the agent/manager trade or business. The court looked at the following primary elements: the time spent in coaching, training, and representing player, which included the diligent "cultivation of clubs, traveling." The court noted the agreement may not be arms length in the normal sense and must be carefully scrutinized, but that the agreement stood "every searching test." Further supporting the case was the testimony of independent witnesses who observed and testified as to the contract's existence.

Thus, it appears that the Service will continue to attack the identification of the income earner but it is clear that in some cases the courts will side with the taxpayer if the child did not control the earning of that income.

THE NINE (PLUS) "PRONG" TEST(S)

Treas. Reg. [section]1.183 is the most litigated aspect of an alleged hobby activity, yet in casual reading it appears to be broad and general enough to consider all valid points that might be raised by an entrepreneur. Unfortunately, the interpretation of the regulation has often been extremely restrictive. Treas. Reg. [section]1.183-2(a) notes in part that "the determination whether an activity is engaged in for profit is to be made by reference to objective standards, taking into account all of the facts and circumstances of each case. Although a reasonable expectation of profit is not required, the facts and circumstances must indicate that the taxpayer entered into the activity, or continued the activity, with the objective of making a profit ... it may be sufficient that there is a small chance of making a large profit ... an investor in a wildcat oil well who incurs very substantial expenditures is in the venture for profit even though the expectation of a profit might be considered unreasonable. In determining whether an activity is engaged in for profit, greater weight is given to objective facts than to the taxpayer's mere statement of his intent" (emphasis added).

Thus, the regulation gives credence for viewing all, not just limited, aspects of the taxpayer's situation. The example of a wildcatter is quite illustrative in that few expenditures of capital can be so worthless or so enriching, and such an argument could be easily raised for a child artist's expenses, as well as any new business venture.

Treas. Reg. [section]1.183(b) views the following matters as critical: (1) the manner in which the taxpayer carries 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, that are earned; (8) the financial status of the taxpayer; and (9) elements of personal pleasure or recreation. The court in Abramson v. Commissioner, 86 T.C. 360, 371 (1986) noted that while [section]1.183-2(b) has nine points it found that no single item is controlling. "A profit objective may be analyzed in relation to the nine factors set out in section 183 regulations, but those factors are not applicable or appropriate for every case. The facts and circumstances of the case in issue remain the primary test." A review of the nine points and judicial reviews notes some interesting and instructive contrasts.

Manner in which the taxpayer carries on the activity.

The Service views as important the carrying on of the activity in a businesslike manner: keeping books and records, following the business practices of similar activities, the change of operating methods and/or adoption of new techniques to improve profitability, and/or the abandonment of unprofitable methods. In James T. Tarkowski, T.C. Memo 1989-379, the court noted there was no profitability, no detailed business records, no plan of business, or no information on how much time spent--all elements which are needed to be considered in a business versus hobby determination. Lundquist v. Commissioner, T.C. Memo 1999-83, noted, among other things, that the intermingling of accounts indicates that an activity is more closely related to hobby rather than business. Golanty v. Commissioner, 72 T.C. 411 (1979), notes that in order to claim business deductions ... the "burden now rests on persons to show that they intended to make profit." In this case, the taxpayer had substantial other income to live comfortably despite losses from horse breeding.

Lou Levy, 30 T.C. 1315 (1958), held that an artist's agent who invests money in hopes that the artist will become a star may deduct the related expenses. In contrast, in Saul H. Nova, T.C. Memo 1993-563, the case involved an agent/father's treatment of his son's golf career via deductions on the father's tax return as a business expense. The litigated issue did not revolve around the notion of a contract existing (i.e., the Carino issue) between father and son; rather, the court held that the sponsorship did not qualify as an activity engaged in for profit because of the taxpayer's "failure to calculate when he would receive a return on his investment" before entering into the agreement. Further, the court pursued a line of reasoning that the taxpayer failed "to require his son to meet goals or financial conditions in order to maintain sponsorship." Christopher J. Bush, T.C. Memo 2002-33 further amplifies the judicial view of business principles and foundations on these matters: the decision was founded on the notion that "petitioner failed to create any type of budget or break-even analysis" in order to determine if a profit could possibly result from the venture. There, the taxpayer did not exhibit any effort to make the achievement of profits possible or the amount of capital necessary to achieve a profit. There was no attempt to obtain clients other than the child, nor were there requirements of expertise in dance or expertise in professional talent management. The court noted that the personal satisfaction Mr. Bush derived from the child's success "proved" the activity was not for profit. Bush operated the activity with a separate bank account and claimed that their intent was for profit.

In Sullivan v. Commissioner, T.C. Memo 1998-367, the profit motive was found lacking when no significant attempt was made to improve profitability. Jesse Rupert, T.C. Memo 2001-179, noted little or no history of engaging in activity for profit nor any personal involvement, and the activity was rules not for profit. The potential for profit was cited in H. Connely Plunkett, T.C. Memo 1984-170, including consideration as to whether the activity was likely to achieve a profit in the future. David Krebs, T.C. Memo 1992-154, was successful for the taxpayer and noted that a businesslike conduct, time and effort expenditure, and knowledge in the business indicated bona fide profit objective. In Rick Richards v. Commissioner, T.C. Memo 1999-163 the taxpayer and wife were respectively engaged in writing and acting/modeling for profit and the court upheld their deductions despite losses. They had hired agents to negotiate screenplay prices, but unfortunately failed to profit due to the natural precariousness of the entertainment business. The wife had kept a journal of auditions and callbacks, had a long history in the profession, and had performed in various plays, commercials, and TV shows. Wiles, Jr. v. US, 312 F2d 574 (1962), held that a business expense deduction was not allowed because a persistent failure to make a profit is a (not the sole) factor that may be considered. Losses that continue beyond the period usually necessary for an activity to become profitable may indicate the lack of profit motive.

The courts seem to constantly raise the bar (see Bush above) on what is considered a normal business activity. A review of these cases suggests that these activities are being held to a higher standard than many existing and legitimate enterprises. It is suggested that numerous operating but otherwise "legitimate" (perhaps more appropriately, profitable) business owners do not prepare a budget, much less a break even analysis; current owners may not even know of this business tool or how to use it. While it is true that new computer programs make the preparation of this analysis simple, the nature of most new businesses cannot be compared to the business practices of larger, well established businesses or the theoretical practices espoused by the courts. Similarly, few small businesses actually prepare business plans unless required to by a lender. While standard software programs are available to accomplish this "requirement," this activity is often perceived as a necessary evil for funding and is rarely completed unless explicitly required. And, when completed, the exercise probably contains little realistic planning.

It is suggested that the cumulative overhead to establish such requirements are prohibitive to many entrepreneurs and the courts are knowingly--or unknowingly--using these "theoretical" devices to deny for-profit determination. It is often opined that a business does not exist if one bank account is used both personal and business purposes, yet the same computer programs discussed previously can easily segregate data and separate the business and personal dimensions, one or two bank accounts notwithstanding. This fact is often overlooked in rational decisions on the subject. For example, numerous businesses--especially construction companies--can use one bank account for various distinct and important "jobs," yet the Service and the courts always seem to use the single bank account issue as the death knell for the struggling start-up business. In summary, in order to establish legitimacy, the courts seem to require a separate bank account, financial statements, record maintenance, good bookkeeping, budgets, break even analysis, corrective methods to achieve better results, return on investment analysis, contractual arrangements (arguable as seen below), and other sophisticated operational aspects often foreign to new entrepreneurs.

The expertise of the taxpayer or his advisors.

Points considered by the Service include the taxpayer's extensive study of accepted business, economic, and scientific practices, or consultation in accordance with such practices, which should not significantly vary unless the taxpayer is attempting to develop new or superior techniques in the business at issue. In Kathleen A. Carr, T.C. Memo 1996-390, it was held that expenses from a talent manager in developing and promoting an artist's career are essential to the business, thus deductible. "Talent managers" must obtain work for their clients in order to generate income for their businesses. Here, the taxpayer "organized, advertised, and put on showcases for directors, producers, and casting people involved in the entertainment industry to demonstrate the talents of her artistry." Accordingly, the ordinary and necessary expenses of a personal manager are deductible if they are incurred while developing the careers of clients. As expected, the manager must show expenses were indeed designed to expose their clients to the industry. The taxpayer bore the burden of proof concerning entitlement to any deductions claimed. Colonial Ice v. Helvering, 292 US 453 (1934). "Normal and necessary" requires that the expenditure be normal, usual and customary, appropriate, necessary and helpful to the operation of the business. Commissioner v. Tellier, 383 US 687 (1966

In David Krebs, T.C. Memo 1992-154, the court looked to a businesslike conduct of activity, time and effort, and noted that a knowledge in the business indicated bona fide profit objective. Similarly, in Clayden v. Commissioner, 90 T.C. 656 (1988) the court noted that knowledge of the industry or consultation from those who know the industry shows the business was intended for profit. In Rick Richards v. Commissioner, T.C. Memo 1999-163 the taxpayer hired agents to negotiate screenplay prices, his wife kept a journal of auditions and callbacks, had a long history in profession, and performed in various plays, commercials, TV shows. Lou Levy, 30 T.C. 1315 (1958), determined that an artist's agent who is experienced in the area and invests money in hopes that they become a star may deduct the related expenses.

In this area, the courts appear willing to accept the taxpayer's hiring or engaging someone with expertise, again, forgetting the average person may not have the resources to afford such advice. While there is no doubt expertise is essential in today's complex world, it also seems that self education, including courses on similar matters, would also be as effective, and while this self education is mentioned in the regulation, the service and the courts seem to place a premium on prior experience and paid or other consultants, as opposed to self educational methods. That said, there are nonetheless court cases that recognize the self education of the taxpayer as an important factor.

The time and effort expended by the taxpayer in carrying on the activity.

The regulation suggests an investigation of the amount of personal time and effort devoted to the activity, particularly if the activity does not have significant personal or recreational aspects, and includes withdrawal from prior occupation to devote to the activity. A limited amount of time dedicated to an activity does not indicate a lack of profit motive where competent and qualified persons perform such activity.

Time and effort is not clearly defined as that expended during the normal work day only. Most entrepreneurs dedicate long hours during non business hours to their businesses, yet these do not seem to be held as critical as those during so-called normal business hours. Once again, if paid or other agents can do the work, the courts seem to have little trouble with this prong, but, again, most entrepreneurs only have themselves and perhaps their immediate family members.

Expectation that assets used in activity may appreciate in value.

The expectation in this alternative prong is that the value of the entity's assets will increase in economic value, accordingly allowing the business owner to eventually report an economic profit, despite possible year-to-year operating losses. In James Tinnell v. Commissioner, T.C. Memo 2001-106, sales from CDs were shown to have realistic future profit potential from an otherwise speculative activity. Logically, early recordings of successful artists are viewed as extremely valuable and traditional assets, such as but not limited to real estate, can be more readily shown to have appreciable value, despite the fact those properties may not be currently generating a positive cash flow.

It is rather interesting that there is no human "appreciation" considered by the Service or the courts; rather, the Code and the Service view "assets" as traditional brick & mortar and technological, as opposed to the most scarce and unique resource of all: human. Naturally, some might be taken aback if we were to view humans as balance sheet assets. In some foreign countries, human capital is recognized and the issue has been debated in the United States. It follows that, when considering other regulation guidance, the human potential for appreciation should be considered rather than ignored. If anything, the human resource has enormous and trainable potential; the prima facie case is made by summing up the countless tax dollars spent for education. Yet when it comes to the provision of a clear and precise path for a prodigy child with a taxpayer's life, the Code discounts the notion.

The success of the taxpayer in carrying on other similar or dissimilar activities.

The Service and courts consider whether the taxpayer had engaged in similar activities in the past and/or converted activities from unprofitable to profitable enterprises despite a present lack of profitability. In Rick Richards v. Commissioner, T.C. Memo 1999-163 the court noted the long history in the profession and the fact that the taxpayer had performed in various plays, commercials, and TV shows. Conversely, in Christopher J. Bush, T.C. Memo 2002-33, there was no showing of the taxpayer's attempt to obtain clients other than the child, and no expertise in dance or professional talent management was required.

The Service and the courts seem to believe a true business should be expansive (e.g., obtain new clients), and quite often this belief is correct. Yet, with limited resources, it must also be agreed that expansive activities too early in the life cycle could doom the business. The multiple failures of attempted mergers of firms with vast amounts of human and financial capital provide ample examples. Further, expansion many times requires the dilution of quality and the additional commitment of personal time, requirements that struggling entrepreneurs simply cannot meet.

The taxpayer's history of income or losses with respect to the activity.

The regulation notes that a series of losses during the initial or start-up stage may not necessarily indicate that the activity has not been undertaken for profit, but losses should not continue beyond the period which "customarily is necessary" to become profitable. Fortuitously, losses sustained due to unforeseen circumstances beyond the control of the taxpayer should not be considered by IRS auditors. In Stella Waitzkin, T.C. Memo 1992-216, a profit motive was established despite a 10-year record of losses. Even though the taxpayer had other sources of income, the taxpayer had gained greater recognition and revenues each year. Compare: John G. Parker v. Commissioner, T.C. Memo 2002-76 where the court held the petitioner was not engaged in "for profit" activities, with one reason being he had a record of substantial losses over many years. In Christopher J. Bush, T.C. Memo 2002-33, the taxpayer did not exhibit any effort to achieve the profits possible or to consider the amount of capital necessary to achieve a profit.

Perhaps the most subjective of all the prongs, the regulation attempted to establish a firm time frame for an "acceptable" loss period. However, as can be seen from the various cases, such a time line is practically unrealistic; each situation is unique. Yet, this three- strikes-and-you're-out mentality pervades.

The amount of occasional profits, if any, which are earned.

The regulation suggests that profits versus losses incurred should be compared to the taxpayer's investment (and assets of the business). From such a comparison, the regulation then views occasional small profits versus a large investment as unpersuasive to the finding that a for-profit enterprise exists; large occasional profits from small loss/investment criteria are considered more compelling. The regulation notes: "An opportunity to earn a substantial ultimate profit in a highly speculative venture is ordinarily sufficient to indicate that the activity is engaged in for profit even though losses or only occasional small profits are actually generated." Hirsch v. Commissioner, 11 AFTR 2d 1156 (1965) noted that a profit or income motive must dominate the taxpayer's business in order to consider the activity a trade or business. Tempering that rather strict view is Hunter v. Commissioner, 91 T.C. 371 (1988), where the taxpayer must have "an expectation" to make a profit, although such a view might not be reasonable but nonetheless allowable as long as they enter into the activity with the profit motive and continue the activity in such a manner. In Stella Waitzkin, T.C. Memo 1992-216 a profit motive was established despite recording losses for 10 years, and despite the taxpayer having other sources of income as the result of the taxpayer gaining greater recognition and revenue each year. Conversely, in John G. Parker v. Commissioner, T.C. Memo 2002-76 petitioner was not engaged in a "for profit" activity, one reason being he had a record of substantial losses over many years.

It would seem here our case of a child prodigy is truly on point with this prong of the tests, as it cannot be denied that certain outcomes (such as singing, sports, and the like) could be highly lucrative. However, the Service argues such is not the case when dealing with human as opposed to "capital" resources, vis-a-vis oil fields and the like.

The financial status of the taxpayer.

The regulation urges a comparison of alternative income and capital versus the suspect activity. It also suggests that substantial income from sources other than the activity (particularly if the losses from the activity generate substantial tax benefits) may indicate that the activity is not undertaken for profit, especially if there are personal or recreational elements involved. For example, in S. K. Johnson III et ux, T.C. Memo 1997-475 the court noted the "fact that taxpayers could afford to operate activity at a loss was irrelevant."

In general, this one prong is often used as an attempt to show that the "true" intent of the taxpayer was simply to provide a tax write off while assisting his child. No doubt this can be the case in numerous audits, however, the regulation is also clear that the review must consider all aspects of the matter, and not utilize a one-size-fits-all approach. Thankfully, it is clear all attributes must be considered.

Elements of personal pleasure or recreation.

While personal pleasure or recreation is considered, it is not necessary that an activity have exclusive intention of realizing a profit or maximizing profits. The regulation notes: "[a]n activity will not be treated as not engaged in for profit merely because the taxpayer has purposes or motivations other than solely to make a profit. Also, the fact that the taxpayer derives personal pleasure from engaging in the activity is not sufficient to cause the activity to be classified as not engaged in for profit if the activity is in fact engaged in for profit as evidenced by other factors whether or not listed in this paragraph." In Henry L. Sutherland, T.C. Memo 1966-155, if the motivation of acting as agent for child was primary for child's benefit as opposed to purposes of [section] 183 [activity engaged in for profit, a/k/a the. 3 of 5 year rule], he cannot deduct expenses. In Christopher J. Bush, T.C. Memo 2002-33, the court noted the personal satisfaction of Mr. Bush received from seeing the child succeed "proved" the activity was not for profit. Conversely, in Cecil Randolph Hundley, 48 T.C. 339 (1967) the business expense deduction was allowed for pro baseball player by the parent/agent. As noted previously, the agreement between the two was based on time spent in training and representing player/child, and it was clear that the ultimate receipt of payment was uncertain and undeterminable. The court looked at the following primary elements: the time spent in coaching, training, and representing player, which included the diligent "cultivation of clubs, traveling," etc. The court noted the agreement may not be arms length in the normal sense and must be carefully scrutinized, but that the agreement "stands every searching test."

The Service and the courts seem to enjoy using this prong as a reason why the situation obviously cannot be for profit. The Bush case above provided good example of assuming the worse and ignoring the realities of the situation. However, the Hundley case is a clear example that, if properly handled, the personal enjoyment factor can be sufficiently negated. To say personal enjoyment is a tipping of the scales seems to be an excessive weighing of the situation, as few people, when being truthful, will admit to doing something constantly if they did not enjoy the situation.

SUMMARY

It would appear that, in order to successfully defend from a hobby loss attack, the following must be achieved, documented, and/or considered: the taxpayer must attempt to follow strictly the guidelines of Treas. Reg. [section]1.183 and consider the various court rulings outlined previously. These requirements seem to include (but appear to be ever evolving expansively): a business plan, a break even analysis, a budget, separate bank accounts, a good accounting system, the conduct of activities in a businesslike manner for profit, utilizing contractual arrangements (although subject to very close scrutiny), and preferably "forming" or conducting the entity as a formal business entity, such as a corporation, LLC, or partnership. There should be consideration of hiring and engaging outside experts, and/or proof of extensive and documented self study, and preferably actual working experience in the area. There appears to be a premium placed on the high devotion of personal time (particularly if one quits a former job and concentrates on the new activity) and effort to the activity during normal business hours, although hired agents are acceptable. If profits are not forthcoming there is an expectation of entity assets appreciating in value, but not human resources. There appears to be a definite emphasis on the entity obtaining more or new clients as quickly as possible. The courts and Service will review the profit and loss history, although history is an oxymoron due to the short time period involved and the definite bias towards the 2 of 5 year rule. The view of speculative risks and therefore occasional profits for highly speculative ventures is ordinarily sufficient but again, not with human resources alone. The activity is likely to be highly scrutinized if the owner has other financial resources and appears to be benefiting from a tax write-off. And finally, while not in and of itself sufficient per the regulation, the notion of personal enjoyment is usually viewed as the 'icing on the cake.'

All of this certainly sounds like a perfect business approach in a perfect world; however, if all the effort is expended on activities such as maintaining records and expending funds, there would be little if any time or resources to expand the business or maintain operations. There is no doubt the courts review the cases individually and with great detail. However, it is suggested that the courts sometimes may forget to recall the trials and tribulations of individuals versus corporate situations, where more structure is normally expected. There is no doubt some taxpayers attempt to take advantage of a system for tax reasons, but many others are attempting to legitimately forge a better tomorrow for themselves and their families.

REFERENCES

CASES

Abramson v. Commissioner, 86 T. C. 360, 371 (1986)

Allen v. Commissioner, 50 T.C. 466 (1968), aff'd, 401 F. 2d 398 (3rd Cir. 1969)

Anthony J. Carino, Jr., T.C. Summary Opinion 2002-140

Blackmer v. Commissioner, 70 F2d 255 (1934)

Cecil Randolph Hundley, 48 T.C. 339 (1967)

Charles Hutchinson v. Commissioner, 13 BTA 1187 (1928)

Christopher J. Bush, T.C. Memo 2002-33

Clayden v. Commissioner, 90 T.C. 656 (1988)

Colonial Ice v. Helvering, 292 US 453 (1934)

Commissioner v. Tellier, 383 US 687 (1966)

David Krebs, T. C. Memo 1992-154

Flint v. Stone Tracy Co., 220 US 107 (1911)

Fritschle v. Commissioner, 79 T.C. 152 (1982)

Golanty v. Commissioner, 72 T.C. 411 (1979

H Connely Plunkett, T.C. Memo 1984-170

Harrison v. Shaffner, 312 US 579 (1941)

Hirsch v. Commissioner, 11 AFTR 2d 1156 (1965)

Hunter v. Commissioner, 91 T.C. 371 (1988)

James M Green, T. C. Memo 1989-599

James T Tarkowski, T.C. Memo 1989-379

James Tinnell v. Commissioner, T.C. Memo 2001-106

John G. Parker v. Commissioner, T.C. Memo 2002-76

Johnson v. Commissioner, 78 T.C. 882 (1982

Kathleen A. Carr, T.C. Memo 1996-390

Lou Levy, 30 T.C. 1315 (1958)

Lundquist v. Commissioner, T.C. Memo 1999-83

Rick Richards v. Commissioner, T.C. Memo 1999-163

S. K Johnson III et ux, T.C. Memo 1997-475

Stella Waitzkin, T.C. Memo 1992-216

Sullivan v. Commissioner, T.C. Memo 1998-367

Valerie Jean Genck v. Commissioner, T.C. Memo 1998-105

Waisbren v. Peppercorn Products, Inc. 41 Cal. App 4th 246

Welch v. Helvering, 54 S. Ct. 8 (1933)

Wiles, Jr. v. US, 312 F2d 574 (1962)

STATUTES

IRC [section] 73

IRC [section] 183

Treas. Reg. [section]1.183-2

Treas. Reg. [section]1.183-2(a)

Treas. Reg. [section]1.183-2(b)

Taylor S. Klett, Sam Houston State University

Margaret Quarles, Sam Houston State University