I vaguely remember a video game with the character Leisure Suit Larry. I’ve never played video games (well, perhaps some online poker) so my knowledge of the games is minimal. From Wikipedia, we find that Larry is,
…though still somewhat lovable, …a balding, dorky, double entendre-speaking, leisure suit-wearing “loser” in his 40s. The games follow him as he spends much of his life trying (usually unsuccessfully) to seduce attractive women.
No, the makers of Leisure Suit Larry didn’t have Larry going through a federal courthouse looking for ladies. Instead, we have the former CFO of Sierra Entertainment (the creator of Leisure Suit Larry) heading to Tax Court on a case involving an airplane, grapes, lending, and lady’s clothing.
First, a word of warning. While I thoroughly enjoyed reading Judge Holmes’s decision, it is long. It runs 76 pages. That said, it is eminently readable by a layman.
Ed Heinbockel is the former CFO. After leaving Sierra Entertainment he ended up running a training simulation company (quite successfully). However, he also had some other businesses that weren’t as successful. He bought an airplane and rented it to others. He decided to add a vineyard near his home. There was a family loan that went bad. And his wife had a successful personal shopping business with plenty of deductions.
An issue that I’ve stressed over and over to my clients is to document, document, and document. If you have good records of your business expenses, an audit will usually go well. The Heinbockel’s didn’t (generally), and their audits for 2005 – 2007 didn’t go well. The case ended up in Tax Court.
Airplanes are expensive. One way of making them less expensive is to rent them out when you’re not using them. However, a key is to keep records of expenses. Additionally, it helps in a court case if the loan when you’re buying the plane doesn’t have the reason for the purchase stamped as “personal.”
Unfortunately for the petitioner, he didn’t keep good records. He didn’t run the operation in a business-like manner. In fact, when the Court looked at the factors (to see if the activity was run for profit), all of them weighed against the activity being for profit.
Next was a lending activity. However, it really wasn’t according to the Court.
They provided no books or records, showed no separate accounts, and proved no active solicitation of business…We find instead an ordinary family deal: They loaned Lydia’s brother money when he said he needed some.
However, the Heinbockels do get to deduct the proven amount of legal fees they incurred in recovering the bad debt as a miscellaneous itemized deduction (so on this issue it wasn’t a total loss).
The Heinbockels looked at starting a vineyard. Unfortunately, the NIMBY crowd didn’t like the idea of a vineyard so the grapes were never planted. The problem for the petitioners was that since they never incurred income from the grapes, the expenses can’t be currently deducted. Instead, they’re start-up expenses that are deductible when the first dollar of income is taken in.
There’s an obvious issue here: What happens when there is never income?
Thus, all of the expenses the Commissioner has disallowed (including those for 2007 on which he had the burden of proof) should have been deferred under section 195 until an active trade or business began. And, since the Heinbockels sold the property in 2007 without ever beginning business, those costs should have been capitalized and added to the basis of the property for computing their gain or loss upon sale.
So the expenses will decrease their gain when they sold the land that they wanted to become a vineyard.
Finally, there was the personal shopping business. The first issue was that this was claimed on the tax returns as Mr. Heinbockel’s business rather than Mrs. Heinbockel’s. The Court rejected that:
With a business named Lydia’s World, it wouldn’t seem to be a stretch to conclude that this was, in fact, Lydia’s business. It certainly wasn’t Ed’s. Throughout trial, Lydia testified that this was her business. When asked to describe Lydia’s World, she described it as “my business;” and her testimony was threaded throughout with the first-person singular….
Then the case meandered into documenting expenses. Unfortunately, there was no written mileage log. The purported business trips had lots of elements of personal pleasure (e.g. a trip to Sea World).
The absence of contemporaneous logs combined with Lydia’s often inconsistent testimony, and the numerous occasions where these alleged business trips appeared to be draped with personal pleasure, cause us to find that none of the travel and meals and entertainment expenses met the business purpose requirement of section 274.
There’s also the records–or lack thereof. “The records for Lydia’s World rivaled Fibber McGee’s closet for their organization.” Luckily for the Heinbockel’s, the Court is allowed to use the Cohan rules for some items (such as Cost of Goods Sold); the court allowed 50% of gross sales. Elsewhere, they weren’t so lucky:
Even when they provided an invoice, the Heinbockels kept such incomplete and disorganized records as to ensure that we can’t tell whether those amounts were already allowed as deductions elsewhere. We therefore find that the Heinbockels have not met their burden to substantiate any deductions that the Commissioner didn’t already allow for 2005. And to the extent that the Heinbockels conceded amounts lower than those reported on Lydia’s World’s 2005 Schedule C, we accept those concessions.
The Heinbockels did win some other deductions for Lydia’s World where there were receipts and records.
The moral of the story is simple: Keep good records! If you have organized records, documenting your expenses, and you run your businesses in a business-like manner, not only will an audit likely go far better, but your Tax Court case (if you head to Tax Court) will go far better than Leisure Suit Larry’s day at Tax Court.