Pedants object to referring to Code Section 183 – Activities Not Engaged In For Profit – as the “hobby loss rule”, because, strictly speaking it is not just about hobbies. Besides being used against people who want to take deductions for things that they just feel like doing, Section 183 has been an IRS weapon in the war against tax shelters.
Well, the pedants scored a point in the meager number of Section 183 opinions in 2021. Nonetheless, I’ll still refer to the section as the “hobby loss rule”. And here we have the hobby loss developments for the year.
A New Audit Guide
The IRS issued Publication 5558 Activities Not Engaged in for Profit Audit Technique Guide Internal Revenue Code Section 183 on September 7, 2021. This is a must read for anyone helping to plan for a potential hobby loss audit or, of course, actually facing one. The last revision was June 2009. I don’t know if the new audit guide is a sign of renewed IRS interest in the issue or simply a matter of them finally get around to it. There is emphasis on how high the stakes are in 183 cases.
IRC 183 adjustments are permanent adjustments and should generally be treated as the primary position unless the alternative issue converts the loss into a profit. The passive activity loss rules of IRC 469, the at-risk limitations of IRC 465, and the basis limitations of IRC 1366 and IRC 704 are timing adjustments and should be treated as alternative positions when the IRC 183 issue is also present.
The guide, as in the past, puts a great deal of emphasis on the nine factors outlined in Regulation 1.183-2. I know you have them memorized, but you have to consider the other readers. Here they are:
(1) 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) Expectation that assets used in 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, which are earned. (8) The financial status of the taxpayer. (9) Elements of personal pleasure or recreation
Key Takeaways From The New Audit Guide
The guide tells agents why their cases get pushed back by Appeals. Oddly, they seem to imply that is a bad thing. The guide encourages agents to talk directly to taxpayers rather than deal with representatives who don’t have all the answers. So if you are a representative, make sure you have all the answers.
There is a great deal of attention to the presumption outlined in Section 183(d). The presumption comes into play if there is profit in three out of five years or two out of seven in the case of horses. If somebody knows one thing about the hobby loss rules it is probably some sort of distorted version of the presumption. If you study the case law, you will find it has little practical significance. There is one very important observation about the presumption in the guide.
Examiners cannot use IRC 183(d) as the reason for disallowing losses under IRC 183 even when the taxpayer fails to meet the presumption.
It is a presumption in favor of taxpayers and can’t be used against them.
The other important point the guide makes is that that Section 183 and the related regulations are close to unchanged from the early seventies. Therefore all of the nearly fifty years of case law remains relevant. Oddly the guide does not have much on the case law. So here is your opportunity to be ahead of the revenue agents. For a roundup of the last decade or so you might want to check out my Honest Objective Trumps Realistic Expectation – Why Tax Practitioners Should Be More Aggressive On Hobby Losses.
The Latest Case Law
Unless I missed something there were only three substantive 183 opinions this year. There were two other opinions that mention 183, We’ll address the latter first.
Carl Gregory TCM 2021-115 is a boat chartering case – a classic 183 activity. Judge Courtney Jones ruling on a motion for summary judgements holds that deductions allowed by 183 (i.e. to the extent of income from the activity) are subject to the 2% floor. No surprise there. Lew Taishoff gave Vivian Hoard, Esq. a “Good Try” for making the argument.
Sang J. Park 136 TC 569 is about a South Korean executive who enjoys gambling when he visits the United States. The opinion is mainly focused on the U.S.-Korea tax treaty. The opinion alludes to 183 noting that the factors are used to determine whether someone is gambling as a trade or business and that the petitioner had not addressed them.
All Hat No Cattle
Stephen Whaltey TCM 2021-11 is summed up in the Tax Notes headline to the text of the opinion – Banker’s Cattle Farm With No Cattle Wasn’t a Trade or Business. Mr. Whatley’s family had been farming and ranching in Lee County, Alabama for eleven generations. I would think they would have had to have started before it was Lee County, which was formed in 1866. Mr. Whatley had some youthful agricultural experience, but found a career in banking more congenial. He was the founder, chairman, president, CEO and largest individual shareholder of Southern States bank.
On its partnership return his operation Sheepdog Farm LLC describes itself as a farm and its principal product as cattle. There was also a lot of timber on the land. Judge Holmes notes:
A cattle farm without cattle and a tree farm that doesn’t yet harvest timber is highly likely to produce a bumper crop of losses.
Nonetheless, Judge Holmes went through the full nine factor drill. The score was 8-0-1. Judge Holmes gave him a break on the fourth factor.
Sheepdog Farms is primarily a cattle farm. Whatley’s old business had nothing to do with cattle at all. And growing timber is different from harvesting and logging it. But we do not want to deny some recognition of those entrepreneurial skills. We’ll call this factor neutral.
Overall there is nothing very instructive here. Lew Taishoff covered the decision with Forget The Hat – No Cattle.
Of course there had to be a horse case. Joseph Gallegos TCM 2021-25 taught me about a new sport – team roping. Judge Holmes peppers the decision with horse puns. Describing Mr. Gallegos’s success in marketing insurance he writes :
The business was a galloping success. Gallegos proved exceptionally talented at spotting people with promise and, once he roped them into a training program and then let them loose in the market, he could share the commissions that they brought in.
As Socrates said a Youtube video is worth ten thousand words, so check this out to get a feel for the sport.
The video is not connected to the case. It is just background. At any rate Judge Holmes gave another 8-0-1 win to the IRS. The judge put the third factor, time and effort as neutral.
Even so, we think the time he put into team roping, though not insignificant, could be done around a normal work schedule and is in line with his lifetime enjoyment of horses.
I ended up passing on covering this case after I spoke to Mr. Gallegos who told me that Judge Holmes had gotten the facts about the sport quite wrong. Ever since I embarrassed myself by totally misunderstanding Olympic dressage competition, I avoid digging into the sports details of my stories. So that is enough on this one.
And For The Pedantic
Preston Olsen TCM 2021-41 is the now rare example of the IRS attacking a tax shelter with Section 183. Judge Lauber notes that more than 200 cases of investors in the same scheme were being held waiting the outcome of this case. Mr. Olsen was involved in a solar energy scheme. The genius behind the whole thing was Neldon Johnson of International Automated Systems Inc.
The idea was to install “Fresnel lenses” on metal towers. The lenses would concentrate sunlight which then somehow or other would produce power. That is neither here nor there as there doesn’t seem to have been much if any power produced. Instead investors would buy lenses which they would lease. It did not end well for Mr. Johnson as you can read in this DOJ press release – Federal Court Orders Tax Scheme Promoters to Disgorge $50 Million in Gains From Fraudulent Solar Energy Tax Scheme.
There are still all the little people to consider whom I guess Mr. Olsen kind of represents. In the final order Judge Lauber confirms a deficiency of $108,791 for the years 2010 to 2014. Judge Lauber took more of a holistic approach and did not march through the factors, although he does refer to some of them.
Basically the lenses were never actually be used as part of a power system, so there was no trade or business. Even if there had been the losses and credits would have been suspended under the passive activity loss rules of Code Section 469.
For what it is worth the Olsens have appealed to the Tenth Circuit. The last item in the docket is that they have been allowed until December 27, 2021 to file their brief.
Section 183 is one of the few areas where I think tax advisers are too cautious. The law is clear that a realistic expectation of profit is not required to sustain a loss. What is required is an honest objective. Hence Reilly’s Eighteenth Law of Tax Planning – Honest objective trumps realistic expectation. You demonstrate the honest objective by behaving in a businesslike manner.
For an expanded version of this argument you can trade an hour of your lifespan to listen to me droning about it here.