We live in a complex society. Even common activities can be exceedingly complex.
Take a charter boat operation, for example. One has to consider the various laws for registering the boat; laws that dictate where and when the boat can operate; the laws governing the crew and its activities; and financing and loan and insurance options and laws. International, domestic, and state and local tax laws also have to be considered.
The tax rules often take a back seat to the other rules at play. Absent advanced tax planning, this can result in significant tax bills. It can also result in significant tax adjustments by the IRS on audit.
The Gregory v. Commissioner, T.C. Memo. 2021-115, provides an example of this. It involves an application of the hobby loss rules to a charter boat activity. The case highlights the tax implication of an activity being characterized as a hobby.
Facts & Procedural History
The taxpayers owned a boat chartering company. It was incorporated in the Cayman Islands. It was taxed as a disregarded entity. Thus, the taxpayers reported the income and expenses on a Schedule C, Profit and Loss from Business, on their personal income tax returns. The chartering company produced losses each year.
The IRS audited the taxpayers’ returns. The IRS auditor determined that the tax losses were limited by the hobby loss rules. In doing so, the IRS auditor moved the charter income from Schedule C on the tax return to “other income” on the first page of the tax return. The IRS auditor also moved the charter expenses to Schedule A, Itemized Deductions. The IRS auditor determined that the expenses were “miscellaneous itemized deductions” subject to the 2 percent floor. This resulted in the expenses not being currently deductible.
The taxpayers filed summary judgment to ask the tax court to conclude that the charter expenses were not miscellaneous itemized deductions. The tax court opinion answers this question.
The Hobby Loss Rules
The hobby loss rules say that losses are not allowable if they are associated with an activity that is not entered into for a profit. There are several factors that establish whether an activity is entered into for a profit.
The hobby loss rules go on to say that expenses associated with hobby losses are still allowable if they would otherwise be deductible. For example, property taxes may be reported as a business expense on Schedule C. If the expense is for an activity that is a hobby, the property taxes may still be deductible on Schedule A. Thus, the hobby loss rules might not limit this type of deduction.
Not all Schedule A deductions are treated the same. Miscellaneous itemized deductions are an example.
Miscellaneous Itemized Deductions
Miscellaneous itemized deductions are defined in the negative. They are deductions other than (1) those allowable in computing AGI and (2) the deduction for personal exemptions. All other itemized deductions are miscellaneous itemized deductions.
As noted in the facts above, this is important as these deductions are subject to a limitation. This limitation is referred to as the two percent floor. It limits the deduction to the aggregate of these deductions to the amount in excess of two percent of the taxpayer’s adjusted gross income (“AGI”). If the taxpayer’s AGI is low, the deduction is limited by this rule. This limitation can apply when the taxpayer has significant income, but has significant offsetting tax deductions.
It should be noted that this characterization is even more significant after the Tax Cuts and Jobs Act (“TCJA”). The TCJA completely eliminates the deduction in some circumstances rather than just limiting it. This case involves tax years that pre-dated the TCJA.
Hobby Losses Are Miscellaneous Itemized Deductions
This brings us back to the issue in this case. The IRS agent determined that the charter expenses were for a hobby activity and the expenses were miscellaneous itemized deductions subject to the two-percent floor.
The court found the answer in the Code. It reasoned that deductions are miscellaneous itemized deductions if they are not one of the specifically enumerated exceptions:
if an itemized deduction, such as section 183(b)(2), is not identified on the list provided under section 67(b), it is a miscellaneous itemized deduction and therefore subject to the restriction provided under section 67(a).
There you have it. Most expenses associated with hobby losses are miscellaneous itemized deductions.
Transactions often produce tax losses. This is particularly true if the activity involves a charitable deduction, bonus depreciation, etc.
Basically, any tax provision that allows for faster recovery of cost outlays can produce losses. These losses could in turn trigger the hobby loss rules. Applying these rules can result in otherwise deductible expenses not being deductible.
These hobby loss rules have to be factored into any analysis of activities that produce tax losses. They are in addition to the start-up rules. The start-up rules can also limit tax losses like these.
Charter boat activities like those, in this case, are an example. This is why it is so important that taxpayers who have losses from charter activities document that their charter activities are not a hobby.