Dear Friends,

So, another tax-filing season is behind us and you’ve really had it. You’ve promised yourself/your spouse that this year you’re finally going to do something to reduce your income tax bill. Such as turn your love of motorcycles (or cake decorating, or furniture re-finishing, or gardening, or…) into a business.

Just a side business; you’re not going to quit your day job. If you lose money, so what? All you’re looking to do is get some tax deductions for the money you already spend on your passion.

What luck! Congress has already anticipated you might be thinking of this. That’s why it passed legislation years ago that created Sections 183 and 162 of the Internal Revenue Code. The former states that losses are only deductible if they are the result of a bona fide business activity; the latter specifies that expenses incurred in connection with a business activity must be “ordinary and necessary.”

As with much of the tax code, these terms are open to interpretation. Taxpayers are constantly trying to “push the envelope” and the I.R.S. is constantly pushing back if it thinks they went too far. (In economic-speak, this falls under something known as “game theory,” and is sometimes referred to as “gaming the system.” Dr. Susan Athey was recently awarded a top prize in economics for her work in this area, as you read in my column last week.)

Take the case of “De Mendoza v. Commissioner.” (All IRS cases are filed on behalf of whoever is the head of the agency at the time, i.e. the “Commissioner.”) Mr. De Mendoza was an attorney who tried to write off his polo playing expenses. He claimed that the only reason he took up the sport was to meet potential clients. In layman’s language, the response of the I.R.S. was: “horse manure!”

The case went to court and Mr. De Mendoza lost. (Perhaps suggesting there is no link between I.Q. and a law degree.)

Then there was Dr. Wilkinson, the plastic surgeon, who also argued that his ranch and polo activities were, essentially, marketing expenses. He claimed the only reason he was hosting lavish parties and rubbing elbows with the rich and, presumably, narcissistic, was to develop candidates for potential face-lifts and liposuctions.

Once again, the tax court found not a wrinkle of evidence that there was any real connection.

In the case of “Zdun v. Commissioner” a “holistic” dentist (whatever that is) tried to justify writing off the expenses associated with his organic apple orchard by claiming they were part of the same activity.

But, after drilling into the facts, the court was not convinced. Not only was Dr. Zdun not making a serious attempt to turn a profit on his orchard “business,” he couldn’t even give the apples away to his dental patients!

In what has to be one of the most blatant and most stupid attempts to stretch the rules, there’s the example of “Henry v. Commissioner.” Mr. Henry attempted to write off the costs associated with his yacht based on the fact that he flew a flag with the numerals “1040” on it. He argued that the yacht was essentially just a means of trolling for clients: he was, of all things, an attorney and a C.P.A.

Need I say more?

Given the above history, it’s particularly surprising that Tracey Topping was recently able to convince the tax court that her equestrian expenses were an integral part of — indeed, essential to — her decorating business. Her case provides valuable lessons to anyone thinking of turning a pastime into a business.

As the tax court opinion states, in 1998, Topping “was 46 years old and in the middle of a bitter divorce.” She “held no job, had no college degree, and had not had any full-time employment in the past 25 years. Her significant assets consisted of a 16-year old horse and a debt-encumbered condo.” In short, Topping suddenly found herself with no obvious marketable skills and desperately in need of income.

She was, however, an accomplished horsewoman. She was also apparently talented and determined.

Topping, who had been competing in equestrian events since the age of 12, decided to parlay her strengths into a business designing horse barns and homes. Participating in horse shows gave her name recognition and access to “the exceptionally wealthy families who participate in the upper realms of the equestrian circuit.”

She hired a certified public accountant and a bookkeeper/assistant and launched her company: Topping White Design, LLC.

Horses are an expensive sport — which is why so many people who own horses attempt to game the system in order to write off some of the costs. To regularly finish near the top of her category, Topping took lessons, hired trainers, and split the $25,000 cost of a membership at the chi-chi and exclusive Jockey Club in south Florida.

To her credit, she earned a net profit of more than $150,000 her first year. In fact, as the court noted, her “overall business enjoyed a net profit 6 of the first 7 years” in operation.

The IRS didn’t quibble with the fact that her decorating and design business was profitable. It argued that her equestrian activities were not related to this business and, thus, could not be used to offset the income she earned from it. To reinforce this, it pointed out that she never advertised her design business at horse shows. In addition, Topper had never written a business plan tying these activities together. In the eyes of the I.R.S. this was further proof that they were not related.

Finally, the I.R.S. claimed that Topper’s riding expenses (such as The Jockey Club membership) were excessive and did not fit the definition of “ordinary and necessary.”

The first issue the court looked at was whether, in fact, Topper’s “equestrian and design undertakings constitute a single activity.”

Topper provided multiple witnesses who testified that “traditional advertising of a personal service business is not welcomed by the clientele” she wanted to attract. Translation: the extremely wealthy find signs, banners, brochures, and other conventional forms of soliciting business tawdry; they don’t respond to them. She also showed that many of her clients were referrals from trainers and other horse-related professionals she used.

In a decision that must have elicited a snort or two at the I.R.S. corral, the court referred to what it called “a plethora of evidence” and ruled that “a close organizational and economic relationship exists between the equestrian and design undertakings …We are persuaded that [Topper’s] equestrian activities are necessary to the success of her design business … [and that they] constitute a single activity.”

In contrast, in the cases cited by the I.R.S. (De Mendoza, Wilkinson, and Zdun), the court said “it is apparent that the recreational activities were an afterthought to the taxpayer’s primary business and were more of a social opportunity than an integrated part of a symbiotic business plan.”

As for whether Topper’s expenses were “ordinary and necessary,” the court offered the following definitions:

“To be ‘necessary,’ an expense must be appropriate and helpful to the taxpayer’s business …To be ‘ordinary.’ the transaction giving rise to the expense must be of common or frequent occurrence in the type of business involved … Even if it is determined that the expenses are ordinary and necessary, they are deductible only to the extent they are reasonable in amount.”

The I.R.S. lost on all three points.

In it’s opinion, the court wrote, “While we are mindful that expenses for personal pursuits do not become deductible expenses simply because they afford contact with possible future clients,…[t]he unique nature of [Topper’s] design business made it an ordinary expense to partake in equestrian-related activities.”

In a clear slap that should have sent I.R.S. attorneys stampeding for the exits, or at least heading back to their books to re-read the tax code, the court concluded that the arguments used by the I.R.S. focused on the taxpayer’s “means to an end, but neglect[ed] the most important fact of all — [her] plan worked. Her startup business was a success form the beginning and continues to be successful."

According to CCH, the tax code provides a “safe harbor” test. “If you made money in 3 of the past 5 years, that’s evidence to the I.R.S. that it’s a valid business,” says Mark Luscomb, principal analyst at the tax and accounting group. 2.

Some obvious take-aways:

1- If you want to turn a hobby into a business, think of things you can do to demonstrate that you’re serious about making a profit. Write a business plan, have stationery and business cards made up, keep thorough and accurate records.

2- The simplest way to avoid problems is to make money! Then it’s obvious that your activity is a business.

3- Be prepared to prove that expenses you claim are typical for the type of business you’re in.

Hope this helps,
Gail

1. Section 183 of the tax code states that you cannot deduct losses from an activity unless it is “engaged in for profit.” In other words, it’s OK to not turn a profit right away as long as it is your intent to turn a profit at some point. Or, as the court said, “The taxpayer’s expectation of profit must be in good faith.”

Under the so-called “gross income test,” it’s presumed that an activity is conducted for profit if gross income exceeds deductions for at least 3 out of 5 years. However, the case of Mitchell v. Commissioner established that ”the presumption applies only after the first profit year.”

2. it’s so difficult to make money in the horse business that it has its own special — and extended — safe harbor rule, Section 183(d): “Activities involving breeding, training, showing, or racing of horses is presumed not to be a hobby if profits result in 2 of 7 years.”

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.