Decisions — Separate from the rest

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Image source: openclipart.org by pnx

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In tax law, one plus one can sometimes equal one. That can be true when you have more than one business and you “aggregate” them into a single activity. Why would you? One reason could be the “hobby loss” rules (internal revenue code section 183). These rules limit the deduction of losses from an activity you engage in if you’re not conducting the activity for profit.

But the definition of “activity” in the federal tax regulations (regulation 1.183-1) say that when you are engaged in several undertakings, each may be a separate activity, or several undertakings may constitute one activity. That means you may be able to combine an activity that generates losses with one that has income, and sidestep the hobby rules.

In T.C. Memo. 2015-243 (Judah), the taxpayer operated a saddlebred horse activity as a limited liability company. The business purpose, as stated in the LLC operating agreement, was “to operate in the horse industry by purchasing, breeding, training, showing and selling horses.”

The taxpayer also had two other businesses organized as LLCs. One was a real estate company whose stated business was to “act as a real estate broker,” and whose purpose was to “perform and operate as a real estate brokerage firm, with duties of sale and leasing of commercial and residential property. In addition, the company is to perform duties associated with managing the development of both residential and commercial property.” The other business was a construction company.

The taxpayer never earned a profit from the saddlebred horse activity. The real estate activities were profitable. Treating the real estate and saddlebred horse activities as a single undertaking resulted in a net profit in at least two of the required seven years.

The IRS audited the taxpayer in 2013 and disallowed the expenses for the horse activity on the taxpayer’s 2008, 2009, and 2010 tax returns. The IRS classified the horse activity as a hobby.

The taxpayer says the horse activity was a marketing and customer development platform for the both the real estate and the construction businesses. He argued that the existence of the horse activity allowed him to network with wealthy horse owners who would be willing and able to purchase real estate.

The IRS maintains the real estate activities were separate and distinct from the saddlebred horse activity and the three did not constitute a single undertaking for purposes of section 183(d).

Here are the factors the court considered when determining whether the activities were a single undertaking. What would you decide on each?

(1) Whether the undertakings are conducted at the same place

During the years at issue, the saddlebred activity was operated from the taxpayer’s personal residence. The real estate and construction activities were operated from an office location.

 

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(2) Whether the undertakings were part of the taxpayer’s efforts to find sources of revenue from his land

The saddlebred horse activity did not use land to generate a profit and did not own real property.

 

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(3) Whether the undertakings were formed as separate activities

The taxpayer commenced the saddlebred horse activity in 1998 but did not initially form a business entity (it was operated as a sole proprietor). On December 6, 1999, the taxpayer formed the saddlebred activity and the real estate company as LLCs. On January 4, 2002, the taxpayer formed the construction company.

 

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(4) Whether one undertaking benefited from the other

The saddlebred horse activity contributed very little to the income of the real estate and construction company. The saddlebred horse activity drained the financial resources of the real estate businesses. The taxpayer commonly transferred funds to cover the operating expenses of the saddlebred activity, but the saddlebred activity never returned those funds because of constant operating deficits.

 

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(5) Whether the taxpayer used one undertaking to advertise the other

The taxpayer displayed a banner for the real estate or construction businesses at horse shows he co-sponsored, but the banners did not advertise the saddlebred activity. The taxpayer also advertised the real estate and construction businesses in the programs of the horse shows he participated in. These advertisements also did not make any reference to the saddlebred activity. The taxpayer argued that the cross-advertising consisted mainly of attending horse shows, which allowed him to socialize with potential real estate customers.

 

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(6) The degree to which the undertakings shared management

The taxpayer was the single member and manager of all three companies.

 

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(7) The degree to which one caretaker oversaw the assets of both undertakings

The taxpayer hired trainers who were the caretakers of the horses. The trainers did not function as the caretakers of the real estate properties.

 

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(8) The degree to which the undertakings shared an accountant

The taxpayer argued that the certified public accountant he hired to prepare his income tax returns, and who also advised him to form separate limited liability companies for the horse and real estate businesses, was a shared accountant by virtue of preparing Schedules C, Profit or Loss From Business, for the various entities. The CPA did not provide any financial advice or services in regard to the saddlebred horse activity.

 

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(9) The degree to which the undertakings shared books and records

The taxpayer maintained separate books and records for each of the entities. He did not consolidate financials at year end to present the financial statements of the three on a unitary basis.

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Based on the above, do you think the court found that the three activities could be combined?

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***

Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

***

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Sorry, wrong answer :(
Right answer!

For the IRS.

The taxpayer did not conduct the saddlebred horse and real estate activities in the same location.

This factor favors the IRS.

Sorry, wrong answer :(
Right answer!

For the IRS.

The saddlebred horse activity did not use land to generate a profit and did not own real property.

This factor favors the IRS.

Sorry, wrong answer :(
Right answer!

For the IRS.

The taxpayer conducted the saddlebred horse activity for nearly two years before forming the real estate company. He also conducted his real estate activities for some time before forming the real estate company. The mere fact that he formally created a business entity to conduct the preexisting saddlebred horse activity does not mean that he commenced the real estate and horse activities at the same time.

In addition, the formation documents of the three companies do not establish that the taxpayer intended for these activities to be operated as a single undertaking.

Consequently, we hold that the taxpayer did not form the three companies as a single undertaking.

This factor favors the IRS.

Sorry, wrong answer :(
Right answer!

For the IRS.

The taxpayer’s real estate activities are not dependent on, or materially benefited by, the saddlebred horse activity.

We are convinced that the benefits each activity derived from the other were merely incidental and fortuitous. The real estate customers were unconcerned with the taxpayer’s involvement in the saddlebred horse industry. Instead, his real estate services were used because of established and trusted relationships or because of his reputable workmanship.

We find no tangible business relationship between the saddlebred horse and real estate activities. The saddlebred horse activity generated little, if any, income for the real estate and construction companies. The saddlebred horse activity did allow the taxpayer to mingle with prospective clients, but we are not persuaded that such conduct created a tangible benefit for the real estate businesses.

This factor favors the IRS.

Sorry, wrong answer :(
Right answer!

For the IRS.

Cross-advertising between the activities was minimal. In addition, the taxpayer could have attended horse shows to mingle with the attendees without the existence of the saddlebred horse business. Such a business practice did not require $1.5 million of expenses. In contrast, it required only the cost of an admission ticket.

This factor favors the IRS.

Sorry, wrong answer :(
Right answer!

For the IRS.

There is insufficient managerial overlap because these entities share management only in the form of the taxpayer.

Sorry, wrong answer :(
Right answer!

For the IRS.

There is no overlap of caretakers between the real estate and horse activities.

This factor favors the IRS.

Sorry, wrong answer :(
Right answer!

For the IRS.

The taxpayer did not employ a shared accountant for the real estate and saddlebred horse activities.

The CPA’s services were limited to preparing the taxpayer’s income tax returns. Other than this, the CPA did not provide any type of financial advice or services in regard to the saddlebred horse activity.

The CPA was required to prepare the taxpayer’s personal income tax return, and in the process, prepared the various Schedules C for the real estate and saddlebred horse activities. We find that the CPA does not qualify as a shared accountant.

The only other shared accountant was the taxpayer, who manually prepared the books and records for all three entities. This overlap is not significant because the taxpayer is also the owner of the entities.

This factor favors the IRS.

Sorry, wrong answer :(
Right answer!

This factor favors the IRS.

Sorry, wrong answer :(
Right answer!

No, the activities are separate.

After weighing all the factors, we hold that the saddlebred horse activity was an activity distinct from the other businesses.
The taxpayer claims he operated the saddlebred horse and real estate activities as a single undertaking. We think this was an afterthought and an attempt to qualify for the presumption under section 183(d).

The two activities were completely unrelated aside from a common owner. The fact that the saddlebred horse activity also allowed the taxpayer to converse with potential real estate clients is not grounds for finding that the real estate and saddlebred horse activities constituted a single undertaking.

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