We have great freedoms in this country. Freedom to express ourselves. Freedom to fish. Freedom to write blog posts. Freedom to pursue any lawful activity to make money. Truly ours is a great civilization well worth tomorrow’s celebration.
But.
To riff on a well worn aphorism: with great freedom comes great responsibility. In particular, as the Sainted Justice Holmes told us: “Taxes are what we pay for civilized society…. The constitutional right…to earn one’s livelihood by any lawful calling certainly is consistent, as we all know, with the calling being taxed.” Compania General de Tabacos v. Collectorv, 275 U.S. 87, 100 (1927).
Three recent cases on Hobby Loss rules teach us about the responsibility of paying taxes to support our freedoms: you cannot lower your taxes by deducting the costs of your personal hobby. The basic lesson is the importance of record-keeping. That means more than keeping proper records. It means properly using the records in a business-like manner. In contrast, having “meticulous” records may just rescue a taxpayer who erroneously mashes up their hobby with a legitimate business activity on the same Schedule.
Two of the three cases present garden variety fact patterns where taxpayers attempt to disguise personal expenditures as business expenses. In Donald E. Swanson v. Commissioner, T.C. Memo. 2023-81 (June 29, 2023) (Judge Pugh), the taxpayer was an emergency room doctor and amateur musician who created a vanity website for his music. In Joseph William Sherman v. Commissionerv, T.C. Memo. 2023-63 (May 17, 2023) (Judge Jones), the retired taxpayer was an avid fisherman who also sometimes hired himself out as a guide, generating some hobby income to reduce his hobby expenses.
The third case is twisty. In Leslyn Jo Carson & Craig Carson v. Commissioner, Dkt. No. 23086-21S (May 18, 2023) (Judge Morrison), the taxpayers mashed up a hobby activity (kids doing rodeos) with a business activity (ranching). What triggered the audit was that the ranch was owned by the taxpayer’ wife’s mom and they had an agreement that all ranching income would be allocated to Mom and all ranching expenses would be paid for and deducted by the taxpayers. So the taxpayers essentially reported massive ranching expenses against modest hobby income. However, these taxpayers’ great recordkeeping overcame their poor reporting, winning a no-harm-no-foul ruling from the Tax Court.
Law: Hobby Loss Rules In §183
One of the fundamental tax lessons to teach students (and clients) is the difference between business and personal expenses. Business expenses can be deducted from business income because Congress recognizes that it takes money to make money. So Congress permits taxpayers to deduct the money it takes from the money they make. The centerpiece of that permission is §162 which permits a deduction of the ordinary and necessary expenses incurred to carry on a trade or business.
In contrast, Congress explicitly denies deductions for any “personal, living, or family expenses.” §262(a). If Congress were to generally permit such deductions, then personal consumption would shelter income. Disney would be delighted. The federal fisc would flounder. By denying deductions for personal expenditures, Congress keeps the tax base broader.
Despite the broad rule in §262, Congress does permit deductions of some personal expenditures. Typical examples are medical expenses and contributions to charity. Hobby expenses are another example.
Section 183 governs the deductibility of hobby expenses. It mediates between permissive §162 and restrictive §262 by permitting deductions for hobby expenses but limiting those to the amount of hobby income. §183(b). That prevents a hobby from producing a net loss. That means the personal consumption represented by hobby expenses cannot be used to reduce other, non-hobby, income.
So whenever a taxpayer engages in an activity that produces some income but produces a net loss, the question is always whether the activity is a business or a hobby. If it’s a business, the net loss can be used to shelter other income (subject to other restrictions such as the at-risk rules and the passive activity rules). You throw everything (income and deductions) on a Schedule C and stick the net profit or loss on the Schedule 1.
If the activity is a hobby, however, then you still report the income on Schedule 1. But you must take your allowable deductions on Schedule A because §183 deductions are §67(a) miscellaneous itemized deductions subject to a 2% floor. Gregory v. Commissioner, T.C. Memo. 2021-115. And, as we all know, Congress has eliminated those deductions through 2025. §67(g).
This proper reporting will be important in our third case, Carson.
An activity is a hobby when income it produces is incidental to the reason for engaging in the activity. The critical question that the IRS and the Courts ask is whether making a profit was the taxpayer’s “predominant, primary, or principal objective” for engaging in the activity. Wolf v. Commissioner, 4 F.3d 709, 713 (9th Cir. 1993). This question about making a profit has nothing to do with the intensity of a taxpayer’s feelings about the activity or the esteem with which the taxpayer is held by others engaged in that activity. A group of golfers may include some who are professional and some who are hobbyists. They all want to win, and they all value their reputations. But only the ones who play golf for profit can deduct a net loss from their golfing activity against non-golfing income.
Section 183(d) helps taxpayers by creating a presumption that if the taxpayer actually made money from the activity for three of the five years before the tax year in question, then the activity is a business and is not restricted by §183. The horse-racing industry has good lobbyists, however, and got Congress to give a more generous presumption for “breeding, training, showing, or racing of horses.” Id. For those activities one need only show profit in two of the prior seven years to get the presumption.
Just because a taxpayer fails to meet the presumption, however, does not automatically make the activity a hobby. Taxpayers will have a more difficult time, however, showing the requisite profit-motive. Treas.Reg. 1.183-2 gives what I like to call a Wobbly Table of Factors (WTF) test that frames how to evaluates the profit motive. The nine factors are: (1) did the taxpayer carry on the activity in a business-like manner; (2) did the taxpayer have or seek to acquire expertise in the activity; (3) did the taxpayer put in the time and effort to show profit-making objective; (4) was there a reasonable expectation that assets used in the activity would appreciate in value; (5) had the taxpayer been successful in carrying on other similar activities; (6) what was the history of income and loss from the activity; (7) what was the size of occasional profits; (8) how reliant was the taxpayer on income from this activity; and (9) what elements of personal pleasure or recreation are involved in the activity.
What makes this a “Wobbly” Table of Factors is that “no one factor is determinative,” and “it is not intended that only the factors described in this paragraph are to be taken into account in making the determination, or that a determination is to be made on the basis that the number of factors (whether or not listed in this paragraph) indicating a lack of profit objective exceeds the number of factors indicating a profit objective, or vice versa.” Id.
Today’s lesson presents two very typical fact patterns for the application of the hobby loss rules. The third case presents a very unusual fact pattern.
Fact Pattern #1: The High-Earner Hobby.
Sherman presents a typical situation where a high-income taxpayer tries to use large personal expenditures to reduce that income by claiming the expenditures were for a business. In this case a high-income doctor created this homemade website (Op. at 4) called “Songswell.” At the bottom of the front page it says “Site created to showcase music to the world.” And not just any music, but Dr. Sherman’s music. Well, he has the freedom to do that. The site contains various short video clips of various water flows and audio clips of various water sounds. The showcase video is a man riding the “swell” of the ocean. Most of the video clips appear to feature Dr. Sherman playing the guitar and singing songs. The site appears to offer many of these clips for sale but when I clicked on the “buy” buttons I basically got a 404 error (page not found).
The year at issue is 2015. That year, Dr. Sherman worked as an emergency room physician, earning at least $143,000. He failed to file a tax return. In 2019 the IRS prepared a Substitute for Return based on third-party information returns and sent Dr. Sherman an NOD showing a tax deficiency of $60,000. That prompted him to file a return. It reported zero income from Songswell but some $105,00 in expenses, a big chunk of which was for specialized AV equipment, such as $51,000 for a “Alexa Mini Camera” and another $20,000 for “Alex[a] Mini Accessories.” You can watch this YouTube video to see what that system looks like. It’s pretty high-end.
Dr. Sherman petitioned the Tax Court (pro se) and claimed that the NOD was in error because (a) he should be allowed a deduction of $52,500 for expenses associated with his medical practice and (a) he should be allowed a deduction of $105,000 for the net loss he in incurred in Songswell, which he claimed was a business. The medical expense claims are not part of the lesson.
Lesson #1: Keep Records, Have Income
Judge Jones dutifully applies the WTF test and finds that each and every factor weighs against a finding that Songswell was a business. I recommend reading this opinion to get a good sense of how all the factors work. However, two factors were epic fails and give use our first lesson.
The first epic fail was that Dr. Sherman did not conduct the activity in a businesslike manner. That main problem was lack of adequate records. I mean, the man did not even keep basic receipts: “Dr. Sherman was unable to produce any documentation or receipts for most of the expenses listed in the “other” category… Further, although Dr. Sherman purchased some camera equipment and accessories in 2015, the amounts on the receipts do not match the expenses reported on Schedule C. Additionally, many of his equipment purchases occurred outside the 2015 taxable year.” Op. at 6.
But even if he had receipts, a taxpayer needs more than receipts to show they are conducting an activity in a businesslike manner. They need basic records of the business activity. Here, Dr. Sherman had none. He had no records to show a business plan or even to show “when Songswell activities began, nor precisely what activity occurred in taxable year 2015.” Op. at 11.
The second epic fail was the total lack of income from Songswell and his substantial income from being a doctor. Writes Judge Jones: “His reported losses from Songswell—in addition to his medical practice expenses—would produce a substantial tax benefit, essentially zeroing out any tax obligation he owed.” Op. at 15.
Judge Jones concludes: “This is not a difficult case… Aside from Dr. Sherman’s self-serving testimony that the Songswell activity was conducted for profit, little else counsels in favor of finding a profit motive…” Op. at 10.
Bottom Line #1: Your vanity website is not a business if you have zero sales over multiple years.
Fact Pattern #2: The Retirement Hobby
Swanson presents another typical situation: a retired taxpayer pursues a long-held hobby and find they can produce some income from it to offset its cost. That does not make it a business. Here, Mr. Swanson was a resident of Alaska who had retired in 2010. His retirement income came from his pension, from Social Security and from rents received on two properties he owned.
Mr. Swanson was apparently an avid fisherman. He had fished in Alaska for over 30 years. He liked fishing for halibut and he liked fishing from a town called Homer, the self-described “Halibut Fishing Capital of the World.” But he lived in Anchorage, some 200 miles away.
After retirement he bought a boat “designed to fish for halibut.” Op at 4. He was apparently able to store his boat and equipment for free in Homer because his “life partner’s children lived in Homer” (Id.). He also bought a plane “to shorten his travel time between Anchorage and Homer.” Id. He apparently was not already a pilot because Judge Pugh notes he held only a student license in the three years at issue (2014-2016). Id.
All of this cost money and Mr. Swanson decided offset his expenses by offering his boat for charter fishing under the name Happy Jack Charters (currently ranked #53 of 63 boat charters in Homer, AK on TripAdvisor). He made some money at it. During the three years at issue (2014-2016), he reported gross receipts of $1,500, $2,345, and $3,709, respectively. Op. at 7. But his reported expenses gave him net losses, totaling $131,000 over the three years.
Like Dr. Sherman, Mr. Swanson apparently was not very good at filing returns. He filed his 2016 return in June 2017 and his 2014 and 2015 returns in August 2017. It is not entirely clear from the opinion, but it appears he was prompted to file returns by an IRS audit. Apparently the IRS was concerned about unreported income. A Revenue Agent conducted a bank deposits analysis, finding deposits for each year exceeding reported income. That’s not routine. The IRS sent him an NOD and Mr. Swanson hired a lawyer and petitioned the Tax Court.
Lesson #2: Don’t Be “Lazy On Your Books”
Unlike Dr. Sherman, Mr. Swanson at least had some income from his chartering activity. And he kept records.
Mr. Swanson at least kept receipts that “he would hand to his accountant at the end of the year ‘to figure it out.’” Op. at 10. But just having income and keeping receipts of expenses is not enough to show an activity is operated in a businesslike manner. Judge Pugh explains that “the key question is not whether the taxpayer keeps records, but whether the taxpayer uses his records to improve profitability and take steps to control expenses and increase income.” Op. at 10 (emphasis in original).
What hurt Mr. Swanson here was his poor recordkeeping. One gets a sense of it from this TripAdvisor review from May 2017: “We caught our limit of halibut. Only downside is he got ticketed by the water cops … lazy on his books they said. Other than that, we really enjoyed the trip.”
Judge Pugh explains how Mr. Swanson was lazy on his books for tax purposes as well. He did not use his records to operate his activity like a business. “Mr. Swanson did not explain whether and how he used the data about his income and expenses to make his activity profitable. *** Mr. Swanson did not have a business plan and made no significant changes to reduce expenses and generate income the entire time he operated Happy Jack Charters. *** Despite the apparent lack of clients and income, Mr. Swanson purchased an airplane and incurred significant expenses related to storing, maintaining, and operating it.. Over the seven years of operating Happy Jack Charters, Mr. Swanson never made changes that enhanced his prospect for making a profit.” Op. at 10-11.
Bottom Line #2: Don’t be lazy on your books.
Fact Pattern #3: The Hobby-Business Mash-Up
Our third case, Carson, presents a very strange fact pattern. Ms. Carson’s mom created a grantor trust and transferred mom’s cattle ranch to it; Mom was trustee. Mom and stepdad were the life beneficiaries of the trust. Ms. Carson and her brother were the remaindermen. During the tax years at issue (2017-2018) Mom and stepdad were living.
Per written agreements, Ms. Carson was obligated to pay the expenses of the ranch. But she was not entitled to any of the income from ranch unless both she and her mom agreed to it. Thus between 2014 and 2019 “[Ms.] Carson made substantial financial contributions to the ranch by paying its expenses. *** The ranch made money mainly by selling cattle. The receipts from the cattle sales were reported on the returns of [Ms.] Carson’s mother.” Oral Transcript at 3. That’s just weird. Normally parents try to assign income to their children, deductions!
It is not clear from the opinion but it appears that the Carsons lived on the ranch. At any rate Judge Morrison says that “the Carson’s two children lived at the ranch helping in the ranch’s business of raising cattle for sale. For this purpose, the children used horses, some of which they also used to compete in cash-prize rodeos. The children also performed manual labor for neighbors of the ranch.”
For the tax years at issue (2017 and 2018) the Carson’s filed a Schedule F, reporting a “livestock” business. However, the only income they reported each year was the cash prizes the kids won in rodeos and the money the kids made from neighbors: some $2,700 in 2017 (all from rodeo prizes) and some $8,000 in 2018 ($6,200 from rodeo prizes). Against that modest income they reported all the expenses Ms. Carson had agreed make: $139,000 in 2017 and $134,000 in in 2018.
This had been the pattern since 2014: “During the six years 2014 to 2019, the Carson’s reported cumulative losses of $502,742 on the schedules F. For each year, these losses not only dwarfed the gross income reported on the schedule F…but they largely offset the Carson’s ordinary income [from] wages.” Yessir, assignment of deductions!
On audit, the IRS disallowed all the Schedule F deductions in excess of the Schedule F income because the IRS Revenue Agent thought that the Carsons had mis-labeled the activity and it should have been reported as a rodeo activity, not a ranching activity. And the rodeo activity was a hobby, not a business. The Carsons petitioned the Tax Court. I cannot tell whether they were represented.
Lesson #3: Hobby + Business = Business?
The basic problem, Judge Morrison decides, is that the IRS mis-analyzed how the Carsons messed up their return. The Carsons’ error was mashing up the rodeo activity and ranching activity on the same Schedule. That led the IRS to mis-analyze the return by ignoring the documented arrangement between Ms. Carson. The IRS approach “supposes that the Carsons lost approximately $120,000 per year entering their children in rodeos. *** [That] makes no sense in light of our view that the deductions reported on the Schedules F mainly related to ranching.” Transcript at 8.
Here, unlike our other two cases, the taxpayers kept good records. Transcript at 8. (Ms. Carson “kept meticulous details of the expenses that were deducted on the Schedule F.”). Those records showed most expenses related to the ranching activity and only a “relatively small part” related to the rodeo activity. Id. Judge Morrison declines to parse the expenses because the IRS “did not challenge the substantiation behind the deductions” id. and thus he was not going to ding Ms. Carson for not bringing records with her to trial.
Bottom Line #3: Don’t try this at home, but once Judge Morrison accepted that the ranching activity was legit, then mashing up the hobby and business was basically harmless error. Sure, the Carsons should have reported the rodeo income on Schedule 1 and not Schedule F. Sure, they should have reported the rodeo expenses on Schedule A (and, of course, for 2018 they would not have been able to deduct any rodeo expenses because of evil §67(g)). The proper reporting position, however, would not have affected their bottom lines very much if at all. The ranching net losses would have still been able to be used to offset the modest rodeo income they had as well as most of their wage income.
Coda: The real issue here—that the IRS just missed—was the assignment of deductions. Judge Morrison notes the weirdness of allocating all the ranching income to Ms. Carson’s mom and allocating all the ranching expenses to Ms. Carson but tells us that a “mismatch of income and deductions is not prohibited under the Code per se, but may be relevant in determining the appropriateness of accounting methods and in determining the appropriate allocation of income and deductions between partners. However, these legal issues are not before the court.”
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) for another Lesson From The Tax Court.
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