Just because you have years of experience in an activity and have made an occasional profit at it doesn’t mean you have a profit motive, according to the Tax Court. And without a profit motive, you don’t get to deduct losses from the activity.
According to a recent Tax Court ruling in Stettner, T.C. Memo 2017-113, Allen Stettner and his wife Julie formed Al Stettner Racing in 2006. They reported net losses of $19,900 and $16,600 on Schedules C for 2006 and 2007. They stopped operating Al Stettner Racing in 2007 and did not report a car-racing activity for 2008 through 2009. In 2009 they filed a chapter 7 bankruptcy petition that they attributed in part to Al Stettner Racing’s losses.
In 2011 Stettner was unemployed and withdrew a portion of his section 401(k) plan account to form AJS Motorsports. Despite having no formal business education and having incurred substantial losses while operating Al Stettner Racing, Stettner was confident he could operate AJS at a profit. He reported losses from AJS for 2011 and 2012 of $63,000 and $16,000, respectively. For 2013, 2014 and 2015 he reported net profits of $3,800, $4,600 and $3,150, respectively.
The IRS issued the Stettners a notice of deficiency for 2011, disallowing Schedule C expense deductions pursuant to Code section 183. The Stettners petitioned for redetermination of the deficiency.
Generally, a taxpayer may not deduct expenses incurred in connection with activities not engaged in for a profit, such as activities primarily carried on as a sport, as a hobby, or for recreation, to offset taxable income from other sources. An activity is presumed to be engaged in for profit if the activity produces income in excess of deductions for any three of the five consecutive years which end with the taxable year.
Evidence from the years after the year in issue is relevant to the extent it creates inferences regarding the taxpayer’s profit objective in earlier years. Section 183(e) allows a taxpayer to elect to defer the determination of whether the presumption applies until the close of the fourth taxable year following the taxable year in which the activity was first engaged in. The Stettners timely filed Form 5213, Election to Postpone Determination as to Whether the Presumption Applies that an Activity Is Engaged in for Profit.
Although the Stettners reported income in excess of deductions for AJS for 2013-2015, the Tax Court found that, in fact, AJS had net losses of at least $2,260 for 2013 and $754 for 2014. Therefore, the Stettners were not entitled to the presumption that AJS was engaged in its activities for a profit. Without the presumption, the court fell back on a nonexclusive list of factors found in the regulations under section 183 (Reg. section 1.183-2(b)). These are: (1) the manner in which the taxpayer carried on the activity; (2) the expertise of the taxpayer or his or her advisors; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that the 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 loss with respect to the activity; (7) the amount of occasional profits earned, if any; (8) the financial status of the taxpayer; and (9) whether elements of personal pleasure or recreation were involved. No single factor is determinative, and more weight may be given to some factors than others.
Of the nine factors listed in the regs, the court found two that favored the Stettners (3 and 8); one factor was neutral (2); and the six other factors favored the IRS. After considering the factors and the facts and circumstances of the case, the court concluded that the Stettners did not have an actual, honest profit objective in operating AJS during 2011. Therefore, the deductions for the expenses paid by AJS were subject to the limitations of Code section 183 and were not deductible to offset taxable income from other sources.
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