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When Is A Business a Business? Taking A Look At Profit Intent

As tax professionals, it seems like we see at least a few situations each year where we ask ourselves if our client’s business is actually a business.

In Swanson v. Commissioner of Internal Revenue, filed June 29, 2023, the US Tax Court judge ruled the taxpayer did not operate his fishing charter activity with a requisite profit intent. This recent case provides a great jumping off point to examine the rules around deductibility of business expenses and profit intent.

Taxpayers are generally allowed deductions for business expenses attributable to an activity engaged in for profit; however, IRC Sec 183 limits deductions that can be claimed when an activity is not engaged in for profit – often referred to as the hobby loss rule. If the activity does not have profit intent, allowable deductions cannot exceed the gross income for the activity.

While a well-meaning taxpayer can believe they are in business, the reality is that the IRS and/or the courts may take a very different view.  Before we look at the case findings, note that the IRS discusses a list of facts and circumstances provided in Treasury regulations to determine if a profit motive exists:

  1. Manner in which the taxpayer carries on the activity:  The IRS reviews if the activity is carried on in a business-like manner, maintaining complete and accurate books and records, and if it’s carried on in a way substantially similar to profitable businesses of the same nature.
  2. The expertise of the taxpayer or his advisers:  Is there adequate knowledge to carry on the activity as a successful business? If so, profit intent may be disproven unless he is developing new or improved techniques which may result in profit.
  3. The time and effort expended by the taxpayer in carrying on the activity:  Does the time and effort indicate profit intention? Is this the taxpayer’s only business activity?
  4. Expectation that assets used may appreciate in value:  A taxpayer may intend that even if no profit from current operations is derived, appreciate of asset values will result in an overall profit.
  5. The success of the taxpayer in carrying on similar or dissimilar activities:  Has the taxpayer engaged in similar activities in the past and been profitable?
  6. The taxpayer’s history of income or losses with respect to the activity:  A series of losses not attributable to unforeseen circumstances may indicate a lack of profit intent.
  7. The amount of occasional profits, if any, which were earned:  Occasional, substantial profit would generally indicate profit intent where the investment or losses are relatively small. Occasional small profit would generally not indicate profit intent where the investment or losses are relatively large.
  8. The financial status of the taxpayer:  The amount of income or capital from sources outside the activity will play a role.
  9. Elements of personal pleasure or recreation:  Profit intent may be indicated where an activity lacks any appeal other than profit.

Mr. Swanson was an avid fisherman and had been fishing in Alaska for more than 30 years. In 2010, after retiring from two jobs, he decided to establish Happy Jack Charters and acquired a boat designed to fish for halibut. Mr. Swanson wanted to show people where to fish and how to fish.

During the years in issue (2014, 2015, 2016) Mr. Swanson lived in Anchorage, Alaska, but his plan was to take people on halibut fishing trips in Homer, Alaska. His life partner’s children lived in Homer, and they let Mr. Swanson store his boat and some other belongings on their property. This allowed Mr. Swanson to reduce his expenses.

Looking at the factors above, here is where the Court ruled against Mr. Swanson (only one factor, noted below, was considered neutral):

  1. Manner in which the taxpayer carries on the activity: Mr. Swanson did not maintain complete business records, did not have a business plan, and did not respond to losses by changing how he conducted his fishing charter activity.
  2. The expertise of the taxpayer or his adviser: Mr. Swanson lacked expertise in running a fishing charter business and did not consult advisers.
  3. The time and effort expended by the taxpayer in carrying on the activity: The years in issue resulted in limited time carrying on the activity by Mr. Swanson. He took no charter fishing trips in 2014 and a total of 11 for 2015 and 2016.
  4. Expectation that assets used may appreciate in value (neutral factor): Mr. Swanson did not address asset appreciation at trial or posttrial briefs, and offered no evidence to show any assets will appreciate in value.
  5. The success of the taxpayer in carrying on similar or dissimilar activities: Mr. Swanson did not address the success of carrying on similar or dissimilar activities at trial or posttrial briefs and offered no evidence on success in other businesses.
  6. The taxpayer’s history of income or losses with respect to the activity: Mr. Swanson started his fishing charter business in 2010 and experienced a loss every year through 2016.
  7. The amount of occasional profits, if any, which were earned: Along with no profit from 2010 through 2016, Mr. Swanson did not attempt to show there is potential significant profit.
  8. The financial status of the taxpayer: Mr. Swanson received income from Social Security, rental properties, and a pension. He did not rely on income from his fishing charter activity.
  9. Elements of personal pleasure or recreation: Mr. Swanson used his boat for personal fishing trips and testified that his retirement plan has been to retire to Homer and fish.

Of note, an activity is presumed for profit if it makes a profit in at least three of the last five tax years (or at least two of the last seven tax years for horse breeding, showing, training, or racing). If a profit is not made in at least three out of five years, the taxpayer must prove profit intent using the factors listed above.

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