Is it a Hobby or a Business?

March 12, 2008

The Tax Court properly determined that plastic surgeon and housewife didn’t engage in yacht chartering and operating activities for profit: taxpayers’ objection to Court’s application of reasonable/objective standard for evaluating profit motive was meritless. And, Court’s finding of no such motive during subject years was amply supported by such facts that taxpayers didn’t carry on activities in businesslike manner, had no prior experience in industry, suffered significant multi-year losses, and used those losses to shield other substantial income; fact that taxpayers may have held profit objective in prior years was irrelevant; and Court wasn’t required to identify exact time/year when taxpayers lost such objective. Also, exclusion of hearsay testimony about taxpayer’s conversations with yacht broker was proper. (Magassy v. Comm., CA, Fourth Circuit, 96 AFTR 2d ¶2005-5086)

The court ultimately concluded that Taxpayers had no actual and honest objective of making a profit in owning, operating, and selling the yacht during the tax years in question. Consistent with this conclusion, the court then found that the chartering activity leading up to the vessel’s sale did not constitute a trade or business for purposes of I.R.C. § 1231.

The underlying facts were undisputed. Dr. Magassy purchased the yacht — a 1963 108-foot Feadship. Dr. Magassy never personally inspected the yacht prior to closing. Instead, his brother in law traveled to Florida and reported back that the yacht was “terrific, … looks great.” But Dr. Magassy did obtain an additional survey, which was conducted by Alexander & Associates on May 9, 1990, also while the vessel was afloat. The survey stated that the yacht’s market value was $1.85 million, its fully restored value was $3.2 million, and its replacement cost was $8.7 million.

Dr. Magassy saw the yacht for the first time in July 1990, when he discovered that it was in a state of total disrepair. Upon returning in November 1990, Dr. Magassy found that little progress had been made on its restoration, and learned that the full $300,000 designated for restoration work had been spent. Dr. Magassy then decided to have the yacht moved to Angus Shipyard in Bayou La Batre, Alabama, for continued restoration work.

At Angus Shipyard, the vessel was removed from the water and extensive hull deterioration was discovered. Despite the initial estimate for restoration work of $218,000, by November 1991, Dr. Magassy had already paid $428,648 and had been billed for an additional $527,637. When Dr. Magassy refused to pay, Angus Shipyard filed a maritime lien against the vessel and a suit in federal court to enforce the lien. The parties ultimately settled the suit in November 1992, with Dr. Magassy paying Angus Shipyard $300,000 in cash and giving it a $180,000 promissory note.

In December 1994, Dr. Magassy created S.M.S.M., Inc., a Florida subchapter S corporation, of which he was the sole shareholder and director and his wife was the secretary-treasurer, and he registered the corporation as a sales and charter boat dealer. Weeks later, he listed the yacht for sale with Richard Bertram Yachts for $2.4 million. The following March, he transferred the yacht’s title to S.M.S.M., and S.M.S.M. borrowed $874,000 to refinance and pay off the NCNB purchase-money loan. Also during this period, S.M.S.M. signed an agreement with Priscilla Yacht Management, whereby the yacht became part of Priscilla’s charter fleet, and the yacht was subsequently featured in a number of print advertisements in chartering magazines. S.M.S.M. maintained separate checking and credit card accounts, and, starting in 1996, an employee of Dr. Magassy’s medical practice began keeping computerized records associated with the company.

From January 1995 until April 1997, the yacht was chartered to paying customers approximately 20 times. It was chartered twice to Plastic Surgery Associates, Dr. Magassy’s medical practice. And members of the Magassy family used the yacht on numerous other occasions. Dr. Magassy’s two sons were aboard the yacht during two March 1995 sea trials and a June 1995 charter by Plastic Surgery Associates. One of his sons was also aboard during a July 1995 charter. Dr. Magassy’s daughter was aboard during one of the March sea trials. Mrs. Magassy was aboard during the first March sea trial, and both she and Dr. Magassy were aboard during the second sea trial, which was a four-day trip from Fort Lauderdale, Florida to Hurricane Hole, Bahamas. On at least three additional occasions, different Magassy family members took personal vacations on board the yacht while it was in the Bahamas. On a number of occasions Taxpayers held dinner cruises and cocktail parties on the vessel, and on other occasions, members spent daytime and evening hours partying on the yacht without staying overnight.

In April, 1997, Dr. Magassy sold the yacht for $1.1 million, realizing a substantial loss.

Taxpayers argue that the Tax Court applied the wrong legal standard to determine whether they had a profit motive under I.R.C. § 183. They assert that the Tax Court’s language reveals that it applied a “reasonable man” standard, erroneously asking whether Taxpayers were reasonable to expect to make a profit, rather than whether they actually and honestly had the objective of making a profit. Second, Taxpayers contend that the Tax Court clearly erred in its factual finding that they lacked a profit motive.

According to Treasury Regulation § 1.183-2(b), “[i]n determining whether an activity is engaged in for profit, all facts and circumstances with respect to the activity are to be taken into account,” and “[n]o one factor is determinative.” In addition, the regulation sets out nine factors for consideration, although “it is not intended that only [those] factors … are to be taken into account in making the determination, or that a determination is to be made on the basis [of] the number of factors” supporting a conclusion. In other words, the regulation intends to be a wide-ranging qualitative analysis. The listed factors, “which should normally be taken into account,” are:

(1) Manner in which the taxpayer carries on the activity….

(2) The expertise of the taxpayer or his advisors….

(3) The time and effort expended by the taxpayer in carrying on the activity….

(4) Expectation that assets used in activity may appreciate in value….

(5) The success of the taxpayer in carrying on other similar or dissimilar activities….

(6) The taxpayer’s history of income or losses with respect to the activity….

(7) The amount of occasional profits, if any, which are earned….

(8) The financial status of the taxpayer….

(9) Elements of personal pleasure or recreation….

In addition, “at all times, the taxpayer has the burden of showing that the activity was engaged in for profit.”

In its opinion, the Tax Court addressed each of the nine factors and concluded that, based on the facts, each suggested the absence of an actual and honest profit motive by the Taxpayers. As to factor (1), the Tax Court found that the Taxpayers’ endeavor was not conducted in a businesslike manner: no business plans or restoration budget was ever produced; no reasonable investigation was made; and the restoration work was not properly monitored. As to factor (2), the court found that Taxpayers had no experience in owning or investing in yachts and that those they relied on as “experts” were all interested parties. As to factor (3), the Tax Court noted Taxpayers’ lack of time devoted to the restoration and chartering of the yacht. As to factor (4), the Tax Court stated that even though Taxpayers might have had an expectation in 1990 that the yacht would appreciate in value, by 1995 any such expectation had evaporated, given the price at which the yacht was listed for sale in 1994. As to factor (5), the Tax Court noted Taxpayers’ lack of any former experience in yacht chartering or restoration. As to factor (6), the Tax Court observed that S.M.S.M. incurred substantial and mounting losses, year after year, and that there was no way by which Taxpayers could honestly have expected to generate positive net income from the chartering activities. In addition, the Tax Court observed that the yacht was listed for sale at a price at which it would have been impossible for Taxpayers to have generated any income. As to factor (7), the Tax Court noted the existence of continuing losses from chartering the yacht and the impossibility of Taxpayers’ profiting from the yacht’s sale. As to factor (8), the Tax Court pointed to Taxpayers’ substantial income from sources other than the loss-producing activity to “indicate that the activity [was] not engaged in for profit, especially if there [were] personal or recreational elements.”. The court noted that the significant losses of S.M.S.M. served to shield Taxpayers’ unrelated income from taxation. And as to factor (9), the Tax Court noted the inherent recreational element involved in the ownership of a luxury motor yacht. These findings are amply supported by the record, and we hold that they appropriately lead to the conclusions under Treasury Regulation § 1.183-2(b) that the Tax Court reached.

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