A successful entrepreneur and life-long drag racing afficianado starts a drag racing business. The business isn’t profitable. The records, according to the entrepreneur, went down the drain when Hurricane Katrina destroyed their facility. The IRS alleges that the whole thing is a hobby, so the expenses are subject to the hobby loss rules, and the taxpayer owes a whole lot of money (and penalties) to the IRS. The Tax Court is left to decide whether the entrepreneur he had an expensive hobby or just a very unprofitable business.
Christopher Johnson is a successful entrepreneur who has always enjoyed drag racing. He decided back in 2003 to start his own drag racing business. Automobile racing in all forms is very expensive; Mr. Johnson had expenses in 2003 – 2005 of $186,282, $221,672, and $154,335. During the same years revenue grew from $1,500 to $2,318 to $3,154. It was no surprise that the IRS selected Mr. Johnson’s return for examination.
One of the things I note to my clients is the need to keep good records. That posed a problem for the petitioners (Mr. Johnson and his wife):
At trial petitioners failed to produce any primary records in relation to CJ Racing for the tax years at issue. Instead, petitioners produced secondary materials in the form of bank and credit card statements in an attempt to substantiate the deductions claimed on their return. Petitioners contend that because the loss of primary documentation was due to the extensive damage caused by Hurricane Katrina, and because they attempted to reconstruct those records from secondary sources, they should be deemed to have met the requirements of section 7491(a). The Court disagrees. While petitioners made an effort to reconstruct their expenses from secondary records, those records were incomplete and inconclusive. Said records were only bolstered and supplemented by the self-serving testimony of Mr. Johnson.
If you live in an area where a natural disaster might hit, consider what would happen if your records were destroyed. What happens if there’s a fire in your building, or your city is hit by a hurricane/tornado/earthquake/whatever? We’ve gone to scanning everything, and keeping backups in multiple locations. It’s not foolproof–the Mayans allegedly predict that this effort is useless come this December–but it leaves me feeling that should something happen to my office, I’ll be able to reconstruct everything. But I digress….
The Hobby Loss rules (Section 183 of the Tax Code) only allow deductions to the extent of income, and then only as a miscellaneous itemized deduction. The key question that must be answered is whether or not, “…the taxpayer is engaged in the activity with the actual and honest objective of making a profit.” A nine-factor test is used.
The first factor is the manner in which the activity is carried on:
The Court has held that a lack of profit motive is indicated where a taxpayer fails to create a business plan or formal budget, fails to estimate income and practice cost control, and fails to maintain a separate bank account for the activity…Specific to the field of drag racing, the Court has also held that a lack of a bona fide profit objective is indicated where the taxpayer fails to procure a substantial sponsorship for his racing endeavor…At trial petitioners did not introduce any evidence to show that they ever maintained complete and accurate books or created a formal budget for CJ Racing either before or after the hurricane. There is similarly no evidence to suggest that petitioners took any measures to implement any accounting controls or operation methods that would be consistent with an intent to increase profitability. Petitioners admitted that they never formulated an actual business plan for CJ Racing. Additionally, it is clear that petitioners did not maintain a separate bank or credit account for CJ Racing. [Citations omitted.]
Add in no sponsorships and things looked to the Court like this was a hobby.
I’d like to say that there were factors favoring the petitioners…but there weren’t. One factor was held to be neutral. First impressions mean a lot, and it appears the impression the taxpayer made wasn’t positive.
There was another issue in this case: The returns were filed late. You are allowed to file returns late if you have “reasonable cause.” And definitely a hurricane that blows away all of your records would be such a reasonable cause. The years at issue were 2003-2005. One issue was that Hurricane Katrina struck in August of 2005, after the 2003 and 2004 returns were due. The petitioners lost that argument. They did win the argument for 2005, however: That return was due in 2006 and it’s quite reasonable to assume that the hurricane caused the delay.
Is it possible that Mr. Johnson truly had a profit motive? Definitely. Unfortunately for him, he didn’t run his drag racing like a business. If you are starting a business similar to this, read this case and do things differently than Mr. Johnson. Write a business plan, have a separate bank account, and keep good records! Trust me, you’ll be happy you did.