It’s been several weeks since my last posting. I took a break due to the last week of classes and preparing and grading final exams. But, now onward and upward …
Previously, I’ve written about the problems of deducting expenses arising from a racing activity that could be labeled as a “hobby.” If the IRS succeeds in labeling your racing a “hobby,” you can only deduct expenses to the extent of the revenue, and the expenses have to be sorted and deducted in a specific order. Bottom line: if it’s a “hobby,” and if you have just a small amount of revenue from your racing, your racing will give you little relief on your tax return, and you’ll have to jump through another set of hoops by having to sort those expenses.
It’s probably clear by now that the “big boys” – those racing teams with lots of money and lots of cars – probably don’t have much to worry about from the standpoint of their racing being classified as a “hobby.” I’m sure that many things keep Roger Penske awake at night, but “hobby losses” aren’t one of them.
And for those who view their racing as a weekend pastime – a true hobby – and have no desire to pursue it any further, the “hobby loss” rules don’t figure much into their thinking. They know they’re just in it for fun, and don’t expect much help from Uncle Sam.
But, it’s the middle group that faces potential problems: the people just starting out, hoping, trying, and betting that racing will be their career. These are the people who need to be fully aware of the hazards of the “hobby loss” rules.
I recently came across a Tax Court case that goes into an analysis of the hobby loss rules in great detail. It gives a good glimpse into the thinking behind the “hobby loss” rules and how they’re applied. On top of that, it’s a relatively recent case (2005). Best of all, the racer-taxpayer won – and he represented himself in Tax Court!
The IRS audited the 1999, 2000 and 2001 tax returns of John E. and Vicki D. Morrissey, and initially assessed them over $18,000 in additional taxes. On these returns, he took large deductions for his racing activities. The sole issue was whether he operated his drag racing activity for profit.
John had been interested in cars all his life and had been involved in some form of racing since 1969. He was a college graduate with a business degree and was a full-time senior vice president and chief financial officer for a Kansas bank. He earned a decent salary and was also a member of the bank’s Board of Directors and its loan committee.
John began racing in 1974. Evidently he was a good mechanic, had good technical skills, and was able to do most of the work himself. His first car was “a relatively simple car” according to the judge’s opinion. He kept detailed computer records of every pass, including weather conditions and the records of his opponents, in an attempt to highlight his car’s strong and weak points. Quite often, he spoke with other drivers and also examined the less successful competitors in an effort to discover the reasons for their lack of success.
He began winning in 1991. He organized his racing schedule so that he could race at events where he’d have the greatest chance of success and usually entered races at tracks that featured lower entry fees and more prize money. He received his Super Comp license from NHRA.
John prepared a detailed budget of estimated expenses for each of his racing years and modified them as circumstances changed. He also kept a separate checking account for his racing activities.
He kept his car in the best possible shape and used quality parts. He concluded that proper maintenance was essential for any chance of racing success.
John knew he would need a substantial sponsor if he were to succeed in drag racing. In 1998, he secured $15,000 in sponsorship money from a local casino. John purchased a new body for his racecar and painted the casino’s logo on it. He acted as a casino’s representative at races and car shows. He also made public appearances on its behalf. He distributed coupons, flyers and key chains and also coordinated the sponsorship of a race with a different track. During this time, he kept detailed records and presented the casino with a detailed report at the end of the year.
The casino did not renew its sponsorship for 1999 or for any year thereafter. He concluded that he couldn’t make a financial success of racing sometime in 2000, but continued to race on a limited basis in that year and 2001 so that he could offer his car for sale and liquidate his racing activity. In the years under audit, he entered eight drag races in 1999 and 2000 each and six in 2001.
John admitted that there were some elements of enjoyment in his racing, but also stated that he didn’t enjoy the heat or the multiple layers of clothing he had to wear.
From 1991 to 1997 inclusive, John sustained continuous losses in his racing activity. For 1998 through 2001, his racing activity looked as follows, from a financial perspective:
1998 $587- profit (taking into account the $15,000 sponsorship)
1999 $20,348 loss
2000 $22,197 loss
2001 $18,826 loss
There are nine factors in the tax regulations that deal with “hobby losses.” Let’s review each of these factors and see how the Court applied them to John’s racing activity.
- The manner in which the taxpayer carried on the activity.
These are code words that mean a “businesslike manner.” Did the taxpayer (in this case, the racer) keep accurate and complete books and records? Did the racer conduct his or her activity in a manner substantially the same as other businesses that are profitable? Were changes made as time went by in an effort to improve his chances of earning a profit?
There wasn’t much question in the Court’s mind that John conducted his racing activity in a businesslike fashion. Keeping detailed records, budgets, forecasts, and a separate checking account were all factors in his favor. He actively sought sponsorship funds and entered races where he had the best chance of winning, measured both by elapsed time and financially. The existence of a profit motive was also evident when he recognized that he couldn’t earn a profit and began to liquidate his racing activity.
2. The expertise of the taxpayer and his advisors.
Did the taxpayer extensively study the accepted business practices and economics of the business that he was entering? Did the taxpayer consult with experts or other people knowledgeable about the business?
John engaged in all these activities. The Court took note of his business skills as well as his mechanical abilities. He also consulted others to enhance his practical knowledge of drag racing.
- The time and effort expended by the taxpayer in carrying on the activity.
Did the taxpayer devote a substantial amount of time and effort in the activity, even though it may not have had substantial personal or recreational aspects?
In this case, John raced a limited amount of times in the years he was being audited (1999 through 2001) because he had lost his sponsorship and was trying to minimize costs. Although John held a full-time job, his schedule was flexible enough to allow him to devote the time needed to racing a limited schedule.
- The expectation that the assets used in the activity may appreciate in value.
This factor may be appropriate for some activities, such as horse racing and breeding, but has little application to motor sports in general. In John’s case, he maintained his car is the best shape he could, given his situation. He had no realistic expectation that the car would increase in value. The Court was inclined to agree.
- The success of the taxpayer in carrying on other similar or dissimilar activities.
Did the taxpayer carry out similar activities in the past that were profitable? If the taxpayer was able to establish and maintain a successful business enterprise in another field, it could show that he or she had the same qualities needed to begin a new business in an unrelated field.
The Court noted that John was an experienced businessman. He served on the bank’s loan committee, where he was responsible for judging the qualities and attributes of other businesses applying for loans. The Court concluded that he possessed considerable business skills.
- The taxpayer’s history of income or loss with respect to the activity.
The Court noted that a history of substantial losses might indicate the lack of a profit motive. Although losses during the initial or start-up phase of a business could be expected, losses after the start-up period may indicate that the taxpayer lacked a profit motive. Losses that were beyond the taxpayer’s control don’t always indicate the lack of a profit motive, and liquidating a business when it becomes clear that no profit can be expected can signify that the activity was profit motivated.
John had start-up losses, and the loss of a major sponsor was out of his control. He entered fewer races in an attempt to cut costs, and he liquidated his racing activity when it became clear that profits could not be achieved. All these facts served to support the existence of a profit motive.
7. The amount of occasional profits, if any, which were earned.
If there were profits from time to time, this could indicate that there would be a practical possibility of earning profits and thus indicate the existence of a profit motive.
John obtained a substantial sponsorship in 1998 and expected it to continue. When he lost the sponsorship, he arranged his racing activities around this fact and reduced costs by entering fewer races.
- The financial status of the taxpayer.
If a taxpayer doesn’t have substantial outside income or capital, this could indicate the existence of a profit motive. On the other hand, should a taxpayer be relatively well-off, this could be to mean that the taxpayer has no profit motivation in the activity in question and is using the activity solely as a means to write off large expenditures for tax purposes.
The Morrissey’s financial situation during the time under audit was stable, but not substantial. The Court noted that both parties used some of their income to support the racing activity.
- Whether elements of personal pleasure or recreation are involved.
The presence of an element of pleasure in an activity may indicate the lack of a profit motive, although, by itself, it’s not the final word.
John testified in court that there were elements of racing he did not enjoy. Although he enjoyed racing, he quit when he determined that he could not continue it.
The bottom line: the Tax Court ruled that John’s racing activity had a profit motive. Thus, he could deduct all legitimate racing expenses, even though they exceeded his racing income.
You should know that this is a special type of court case that can’t be used as a precedent. You can’t go into court and mention this case to strengthen your position. I know that this is a long posting, but I wanted to go into the details so you could see and understand the various issues that are involved and questions that are raised to determine whether a racer or race team has a “profit motive.” Answering that question can have a great deal of impact on your activity’s finances.
The moral of the story is clear. Racing can have a profit motive, but you need the assistance of a tax and accounting professional, and you absolutely must document all your activities.
The past few posts have dealt with some real-life examples of the factors that can lead to racing being labeled as a “hobby.” Next time, I’ll shift gears (pardon the pun) and spend a little time on the “sorting” of expenses that you must do if your activity is a “hobby” – how it’s done, and what the consequences can be.
Until next time …
Phil Schurrer
(The legal citation for this case is Morrissey, TC Summary Opinion 2005-86)
“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.
