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:
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
Very helpful!
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