Depreciation of Collectible Cars

In 1971 the IRS audited Harrah’s Club of Reno, a casino that operated hotels and gambling casinos. To attract patrons, Harrah’s maintained a museum of about 1,000 antique automobiles. It was successful; over 200,000 people visited the museum in that year.

The casino purchased and restored these antique cars, acquired in various stages of deterioration. The museum itself was housed in a 10-acre complex, and included display areas, restoration workshops and an extensive research library. Over 150 people were employed in the museum and restoration areas.

The Tax Court arguably gave the best description of Harrah’s restoration process:

“The…restorations involve extensive showroom-or-better quality replacements and additions of body, engine, upholstery, lights and paint. Each restoration is preceded by historical research into the specifications of the original vehicle. Restoration is then carried out with meticulous attention to every detail…at great cost. Upholstery and paint are reproduced as they were originally. Entire portions of the body and engine, down to individual engine parts, are renewed, to the extent of making castings from borrowed samples of parts whose replacements cannot be found…(Their) restorations have such an excellent reputation for quality that they add a premium value to the…restored vehicle.”

The tax case[1] involved the proper tax treatment of restoration costs for 94 vehicles. Harrah maintained that these costs should be deductible in the year they were incurred.

The IRS opposed that position, and stated that the restoration costs were capital in nature because they would benefit more than one year. The government relied on a tax regulation that stated that normal repair costs can be deductible as an expense, but those costs that either added to the value or prolonged the life of the asset (the antique cars) were not deductible, but should be capitalized and added to the original cost of the asset.

In response, Harrah stated that if the restoration costs were to be added to a capital account, then they should be depreciated over a period of five to ten years.

The ball was in the IRS’s court. The government then played their ace: depreciation can only occur if the cars had a useful life that could be reasonably estimated. The cars, once restored, could last indefinitely. They pointed out that antique cars were held and displayed in the Smithsonian Museum for decades with no deterioration. Bottom line: no depreciation deduction.

Harrah then played its final card. They responded that, since many of the cars had a market value greater than a normally restored vehicle (due to Harrah’s first-class restoration techniques), the difference between the market value and the costs of restoration plus the initial cost should be deductible or depreciated.

An example of Harrah’s position might help. Recently, I saw a 1985 Firebird for sale for $1,500. The engine needed work and there was some rust on the body. If I paid the $1,500 for it, and decided to restore it to “showroom condition” and display it, I would need to spend, say $10,000. At this point, I would have  $11,500 in the ‘Bird.

But maybe the market value is only $9,000, even for one in prime condition. Using Harrah’s initial logic, I’d want to deduct the $10,000 in restoration costs. IRS says no; it has to be capitalized. I now have an $11,500 asset, and the next best option for me from a tax standpoint is try and depreciate the $11,500.

Again, IRS says no, because the car now has an indefinite life. So, my last attempt to get some tax benefits from this deal is to try and depreciate the $2,500, the difference between the total costs expended ($11,500) and the market value ($9,000).

IRS again says no. The excess of the initial price and restoration costs over the market value of the car can’t be depreciated. The $2,500 is part of the $10,000 in restoration costs and can’t be separated.

Bottom line: Harrah’s Casino was unable to get any tax benefits from the restoration costs until the vehicles were sold.

Those who collect and restore cars can probably expect the same tax treatment. Recommendation: save all restoration documentation and sort it for each vehicle. It will be needed to figure the tax gain or loss when the car is finally sold. It appears that the year of sale will be the only time when tax benefits – if any – will be available for car collectors.

Footnote: Bill Harrah died in 1978 and Holiday Inn purchased the remaining shares of stock in the casino. Included in that purchase was the vehicle museum, which then had about 1,400 vehicles in its collection. Holiday Inn auctioned off the majority of the collection for about $100 million net. A small portion of that collection now forms the basis of the National Automobile Museum in Reno.

Let me know if you or your group would be interested in a presentation going into these topics or other tax and financial aspects of motor sports. I'd be interested in hearing from you.

 Contact me at:

phil.schurrer.racingprof@gmail.com

Until next time …

Phil Schurrer, CPA

“This posting is intended to provide general information regarding the subject matter covered. It is provided with the understanding that the author is not engaged in rendering legal, accounting, or other professional services. This information should not be used as a substitute for professional advice in specific situations. If legal advice or other expert assistance is required, the services of a professional should be sought.”
     - Adopted from a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers.

Attorneys and other professionals dealing with specific matters and situations should also research original sources of authority.

---

[1] Harrah’s Club v. U.S., US Ct. Claims, 554-77, 9/23/81

Tax Aspects of Car Collecting and Restoration

From the beginning this blog has focused on the tax problems faced by race team owners or drivers. Now let’s turn the spotlight and look at on the potential tax problems of those who collect and restore automobiles.

The rules about hobby losses still apply. The nine rules mentioned earlier are still valid for both collectors and restorers. Bottom line: the collector/restorer has to document the existence of a profit motive if he or she hopes to deduct any expenses over and above the amount of revenue earned. And there’s usually very little revenue in car collecting or restoration until the car is sold. (And that involves another set of tax rules, which we’ll review in a future blog.)

Profit Motive Illustrations for Collectors and Restorers

As we’ve seen, the experiences of others who have battled the IRS in court are helpful and provide us with some idea of what – and what not – to do. This is called the “case method” of learning, and it’s used extensively in law schools and graduate business programs. It teaches lessons from the problems of real people in real-life situations. We can learn a great deal from the experiences of others. Racecar drivers talk with other drivers, and team owners share experiences.

There are three tax cases that directly relate to car restorers and collectors.

The first deals with a 1978 Tax Court case involving Richard and Evelyn Smith of Xenia, Ohio.[1] On their1973 tax return, they claimed $4,720 in deductions for repairs and restoration costs relating to a 1957 Ford Thunderbird that they had purchased for $500. The car was sold in January 1977 for $4,500.  Upon audit, they were assessed $1,663 because the IRS disallowed the repair costs.

At trial, the taxpayer claimed two reasons for purchasing and restoring the T-Bird: investment, and the pursuit of a hobby. He further claimed that the expenses were made in order to make a profit. (If it’s a hobby, it doesn’t have a profit motive. You can’t have it both ways.) The IRS claimed that the expenses were not made with the expectation of profit. Furthermore, they claimed that the expenses were capital in nature and not deductible.

Although the taxpayer claimed a profit motive, he admitted that he knew nothing about car restoration and personally did very little work on the T-Bird. The court ruled that Smith offered no proof (other than his own testimony) about the existence of a profit motive. The court noted that over five years had passed between the purchase of the car and its sale. They reasoned that a profit-motivated owner would have sold it earlier. Smith offered no evidence of any unsuccessful attempts to sell the car.

Bottom line: if you’re going to claim a profit motive for car restoration, be able to document your expertise, your sales attempts, research done about car prices for a particular make and model before you purchase – in short, everything a professional restorer with a goal of making a profit would do.

(Incidentally, Smith represented himself at trail. Presumably, an attorney would have made sure that he never uttered the word “hobby” in court.)

The second tax case involves the 1993 Tax Court decision regarding Lynn Crawford, a Dallas physician.[2]  Dr. Crawford received his medical degree in 1978, and began an auto restoration business in 1982. He located it in Louisiana on his parent’s property, which was a three- to five-hour trip from his house. He would work on cars over weekends and occasionally hire others to help him. On his tax returns for 1983 through 1986, he claimed losses of nearly $40,000, of which approximately $21,000 consisted of depreciation. His only records were spiral notebooks, and the entries in them were generally not made at the time the transactions took place.

The Tax Court applied the nine factors associated with the hobby loss rules and ruled that Dr. Crawford came up short. He had no backup for any of the expenses, kept no record of the cars being restored (nor were the car titles in his name), kept no budget, took depreciation on inventory (a no-no), and couldn’t explain why his restoration business was located so far away from his residence.

There were a number of other issues in this case, but for motorsport participants the lessons are clear: a profit motive must be documented.

The third case, involving Floyd and Dorothy Garrett [3] of Florida, can shed some light on the problem of using the wrong bank account to pay for cars added to a collection.

Floyd owned two trucking companies and used the bank accounts from these businesses to purchase additions to his muscle car collection, which he began in the mid-1970’s. At one time, he owned 35 cars. He had hoped to start a museum to house his collection.

In January 1989, he sold 25 cars for $1,200,000. On that year’s tax return, he claimed a cost of $800,000 for the cars and his return showed a taxable profit of $400,000 on the sale.

The Garrett’s returns for 1989,1990 and 1991 were audited. During these years, approximately $624,000 was paid out of his two corporations relating to his muscle car collection.

Floyd faced two big problems:

• First, he never purchased the cars with his own personal funds, although the cars were titled in his name. Therefore, he couldn’t claim the cost of the 25 cars sold because he didn’t personally pay for them. Also, he couldn’t document how he arrived at the $800,000 amount. Result: the entire $1,200,000 was subject to tax.
• Second, since his businesses didn’t own the cars, they couldn’t claim any expenses relating to them. Result: all expenses were disallowed.

It may seem as though the IRS was splitting hairs, but the lesson is clear: make sure all your i’s are dotted and t’s are crossed.

The Garrett’s also had the usual hobby loss problems. He admitted that the car collection was a hobby prior to the 1989 sale and couldn’t show a profit motive for the car collection. No bank statements, cancelled checks or corporate records were provided. The court found Floyd’s testimony “vague, confused, self-serving and uncorroborated.” (Ouch.) The case came to trial in 1997 and a museum building was in the final stages of completion, but no museum had been established. This also was a factor in the court’s finding of a lack of a profit motive. 

Summary

• The hobby loss rules apply. Review the nine factors used by the IRS. 
• Document, document, document. And the time to do it is when the transaction takes place and details are fresh. Don’t begin the collection of paperwork the day you get the IRS audit notice. Memories fade, paperwork gets lost (or tossed), and the consequences can be expensive.  
• Make sure you get professional help. Some of these rules can be tricky. You wouldn’t trust an engine rebuild to just anyone; the same holds true with other aspects of motor sports, including the business or financial end of it. (Of course, if you can claim your racing, collecting or restoring as a hobby, your life becomes simple. Just include all income on your tax return and don’t deduct any expenses.)

 In the future, we’ll continue our look at the tax aspects of car collecting and restoring, and focus on valuation questions, depreciation and capital expenditures.

Let me know if you or your group would be interested in a presentation going into these topics or other tax and financial aspects of motor sports. I'd be interested in hearing from you.

 Contact me at:

phil.schurrer.racingprof@gmail.com

Until next time …

Phil Schurrer, CPA

“This posting is intended to provide general information regarding the subject matter covered. It is provided with the understanding that the author is not engaged in rendering legal, accounting, or other professional services. This information should not be used as a substitute for professional advice in specific situations. If legal advice or other expert assistance is required, the services of a professional should be sought.”
     - Adopted from a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers.

Attorneys and other professionals dealing with specific matters and situations should also research original sources of authority.

---

[1] Smith, 37 TCM 325

[2] Crawford, 65 TCM 2540

[3] Garrett, 73 TCM 2799

Numbers – and A Note of Thanks

On this Independence Day, I’ve found myself with a little spare time and thought I take a look at the statistics for this blog. (I don’t track my own page views.)

I was amazed to discover that the blog had been viewed 170 times since it first began on 12 March of this year. I don’t have any experience or background to determine if this is the norm with other blogs in the initial phase of existence, but I’m truly pleased, especially since it's directed at a rather narrow topic. 

The viewing has been steady and it seems to have attracted somewhat of a worldwide audience. So, being an accounting and tax professor, I felt compelled to share some numbers with you:

      Month                     # views

March	40
April	38
May	36
June	39
July – to date	17

     Country                     # views

United States	146
Germany	9
Zimbabwe	6
Argentina	2
Brazil	2
United Kingdom	2
Canada	1
Philippines	1
Singapore	1

I’d like to thank everyone who has taken the time to look at the blog. Hopefully you’ve found something both interesting and valuable.

One thing I’ve noticed is the lack of comments, either at the bottom of the blog, or posted on the contact URL that I insert in the blog itself. I’d appreciate any comments (positive or negative), suggestions for future topics, questions, or inquiries about my speaking to your group or organization about the tax and financial aspects of motor sports.

Once again, thanks for your viewing, and I look forward to your comments.

Contact me at:

 
phil.schurrer.racingprof@gmail.com

Best regards,

Phil Schurrer, CPA

Understanding Motorsports’ Financial Statements

Every racer and team manager or owner quickly realizes the importance of money in a racing organization.  Budgets, cash flow, and endorsement income rank right up there with elapsed times, lap speeds, RPM’s, chassis adjustments and horsepower.

This blog is designed to give you some insights into the reading of financial statements – that collection of numbers that your accountant or bookkeeper periodically gives you, with the expectation that you’ll understand their significance.

One of the difficulties of being a racing team manager owner is that many financial concerns ultimately come down to one or two questions, such as: ”How much is this going to cost?” and “Do we have enough cash for the next race?”

There are a few motorsports companies, such as Speedway Motorsports, Inc., or International Speedway Corporation, whose financial information in easily available. That’s because they’re public companies and their stock is bought and sold on stock exchanges. These companies are registered with the U.S. Securities and Exchange Commission, and by law anyone can look at their financial statements.

If you were to look up the numbers for any publicly held company, you’d soon be buried under an avalanche of numbers and footnotes. It’s not unusual for a publicly held company’s report to exceed 75 pages.

But, you’re a manager or owner of a small racing team and you’d like to get the most useful information in the least amount of time, hopefully, the following information will help.

  

For our purposes, there are three basic financial statements:

·        The income statement, also known as the profit and loss sheet.

·        The balance sheet, and

·        The statement of cash flows.

Each of these statements focuses on a different financial aspect of the business operation and they’re integrated. The ending balance of one statement influences another, just as the pressure of a brake pedal is transmitted through the fluid in the brake lines to the brake caliper. Both the financial statements and the brakes form a complete system. Every component is essential.

Let’s take a look at each financial statement in some detail.

The Income Statement is the first statement prepared. It shows the profit or loss at the end of a time period. It does this by listing all the items of revenue and then subtracting from that total all the expenses. If the result if positive, the business has a profit. If it’s negative, the business has suffered a loss for that time period.

Some things to remember about the Income Statement:

·        Not all money that comes into a business is revenue. If a business raises money through a sale of stock or a bank loan, the income statement isn’t affected.

·        The profit amount will be the stepping-stone for determining the income taxes of a firm. There are adjustments to be made to convert that profit number to taxable income. This is a special area for accountants.

·        Profit is not the same as cash. An increase is profit doesn’t always equal an increase in cash. It’s very possible for the cash balance to increase (say, through a loan) and the profit to decrease (because of the interest expense associated with the loan).

·        Income statements cover a period of time – a month, quarter or a year.

The Balance Sheet is a listing of what the business owns (Assets), what it owes (Debts or Liabilities), and what’s left over (Equity). Putting it another way, if a business – any business – were to liquidate and sell all the assets, convert everything to cash, and pay off all debts, any amount left would go to the owner(s). The total amount of assets must always equal the amount of liabilities plus the equity amount.

Some additional items about a Balance Sheet include:

·        Balance sheets are prepared as of a specific date, usually year-end or the end of a quarter or month.

·        Assets include cash, accounts receivable (what others owe the business), prepaid rent and insurance, equipment (such as the equipment covered in a previous blog on depreciation), and inventory. (Unless a racing team purchases items for resale, it’s doubtful that there’s much if any inventory.)

·        Liabilities are debts owed to other firms, such as for supplies, parts, taxes, payroll, and advertising – the list goes on and on as you well know.

·        Equity is the owner’s financial interest is in the business. Any profit for the year is added to equity; any loss is subtracted from it. This is an example of the integrated nature of financial statements mentioned earlier.

·        A well prepared Balance Sheet separates the assets and liabilities each into “current assets” and “current liabilities.” Current assets are cash and those items that will be converted into cash or used up in a year. Current liabilities are those debts that will be paid within a year. This distinction is important and has everything to do with “working capital.”

·        Working capital is the result of subtracting current liabilities from current assets. If the result is positive, then the business can be viewed as being able to pay its bills on time. If the result is negative, the conclusion is the opposite and is a warning sign. 

The Cash Flow Statement is a “diary” of cash ins and outs – inflows and outflows – organized into three categories or “activities.”

·        Operating activities – the day-to-day operations of the business. For racing teams, this has everything to do with placing a car and driver in a race.

·        Financing activities – the raising or money through sale of stock or borrowings. The three ways a business raises money are through profits, through sale of stock, or through loans. The last two items each have good and bad features; profits are always good. (Larger profits are even better.) You should also know that selling of stock of your racing team to anyone who’ll buy it may be illegal. You absolutely need to consult with an attorney on this.

·        Investing activities – the spending of money on fixed assets, such as equipment, dynos, cars, etc. In this context, “investing” does not mean the buying of stocks and bonds with excess funds. (Frankly, for most racing activities, “excess funds” are non-existent.)

·        The ending balance on the cash flow statement must equal the ending balance of cash on the balance sheet. (Another example of financial statement integration.)

A major focus of a Cash Flow statement is the amount of funds generated through operating activities: prizes, endorsements, contingencies, etc. If a business continually funds its operations through financing activities, that business has a difficult future.

Two absolutely vital financial characteristics of a business that need to be kept in mind at all times are profitability and solvency.

·        Profitability – the ability of a business to consistently make a profit. By doing this, the survivability and long-run prosperity and success of the business are greatly increased. The key indicating number reflecting this is the profit or “net income” amount on the Income Statement.

·        Solvency – the ability of a business to pay its bills. The prime indicators for this are the working capital numbers mentioned above and the analysis of the cash flow statement.

Profitability and solvency are not the same. It’s very possible for some businesses to have large amounts of profit in the beginning of their existence, but insufficient cash. Both are needed. A racing team needs to establish a pattern of profits to insure its survival and keep it solvent so it can pay its bills.

When I talk with my students or clients, I always mentioned “Schurrer’s Laws of Business Survival”

·        There’s no such thing as excess profits, provided they were arrived at honestly

·        The game is over when the money runs out.

·        You can do many things with cash and no debt

·        May your taxes double next year. This means that your net income (profit) will have risen by the same factor, all things being equal.

Profitability and solvency (as well as many other factors) can be determined by property understanding and using financial statements.

Remember, no one every bought a quarter-inch drill bit because he wanted a quarter-inch drill bit. He wanted a quarter inch hole. Financial statements, like drill bits, are tools. Use them well.

Let me know if you or your group would be interested in a presentation going into these topics or other tax and financial aspects of motor sports. I'd be interested in hearing from you.

 Contact me at:

phil.schurrer.racingprof@gmail.com


Until next time …


Phil Schurrer, CPA


“This posting is intended to provide general information regarding the subject matter covered. It is provided with the understanding that the author is not engaged in rendering legal, accounting, or other professional services. This information should not be used as a substitute for professional advice in specific situations. If legal advice or other expert assistance is required, the services of a professional should be sought.”
 - Adopted from a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers.

Attorneys and other professionals dealing with specific matters and situations should also research original sources of authority.