183-2

Technical topics regarding tax preparation.
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So I wrote earlier about profit motive via business like manner (1st of 9 factors in 1.183-2).

It looks like it got decent responses so I thought I would touch on the second factor sometimes used to establish profit motive of trade or business - expertise of taxpayer or advisors. I figured it would help me learn too.

For reference the Reg. the cases involve: 1.183-2(b)(2) The expertise of the taxpayer or his advisors. Preparation for the activity by extensive study of its accepted business, economic, and scientific practices, or consultation with those who are expert therein, may indicate that the taxpayer has a profit motive where the taxpayer carries on the activity in accordance with such practices. Where a taxpayer has such preparation or procures such expert advice, but does not carry on the activity in accordance with such practices, a lack of intent to derive profit may be indicated unless it appears that the taxpayer is attempting to develop new or superior techniques which may result in profits from the activity.

Below are some things I took away from some cases followed by some case snippets:
1) There is distinction between understanding the mechanics/technical aspects of the activity itself (ex. how to breed horses) and the economics of the activity (how to turn a profit).
2) It seems like where a taxpayer succeeds, there is a clear recognition of their expertise and ignorance, and evidence exists of their seeking of an expert to make up the missing component (mechanics/economics).
a) Seems to be looked upon favorable when they seek advice before engaging in the activity (extra points for business plan)
b) Seeking an expert may help, but seems to help more so when knowledge is salient (not general accounting or legal), principal objective of advice evidenced to profit-motive, and proof of utilizing advice or reason for not employing (actually ignoring the expert may give evidence of innovation and business judgment)
c) Outright hiring employees can help as well (works better when you can demonstrate abilities of employee)
4) Objectivity did seem to matter in at least one case - experts within an organization were deemed biased and not held in favor of taxpayer.


Farris v. Commissioner, 1972 T.C. Memo. 165

The fact that petitioner keeps adequate books and records and seeks the assistance of her accountants is also a strong indication of the presence of a profit-making motive. Norton L. Smith, 9 T.C. 1150">9 T.C. 1150, 1155 (1947). We have also given weight to the employment of professional help in running the horse operation. Morris A. Stoltzfus, supra.

William R. Huff et al. v. Commissioner

The Huffs had no prior experience in breeding, boarding, buying, or selling miniature donkeys when they first contemplated embarking on the miniature donkey breeding activity. Mr. Huff nevertheless commissioned deep research into nutrition, soil quality, waste management, water supply, and other aspects of running a miniature donkey breeding business. Most significantly, Mr. Huff [*29] enlisted the help of Mr. Papetti, who was involved in miniature donkey breeding and advised him about the industry and market. The Commissioner notes that the Huffs' consultations with experts focused on the operational aspects of the miniature donkey activity and not its economics. This is unsurprising. Mr. Huff's investment background provided the Huffs the necessary perspective to understand the economics underlying the business. Thus, they appreciated that Mr. Papetti's offer to sell 12 donkeys for $10 and future rights was not a good deal, as they would be responsible for all expenses but entitled to only a portion of profits. Their grounding in economics taught them it was better to look the gift donkey in the mouth (to tweak the old saw). What the Huffs lacked was insight into the practical aspects of caring for and breeding donkeys — precisely what they sought to obtain through their research and the advice of Mr. Papetti.

The Commissioner points out, however, that the Huffs ultimately did not pursue the course plotted by Mr. Papetti as to breeding methods. The Huffs' decision to reject that approach was consistent with an attempt to implement a new technique to turn a profit, as contemplated by section 1.183-2(b)(2), Income Tax [*30] Regs. Mr. Huff believed that Mr. Papetti's breeding program was too aggressive and might be one explanation for stillborn births. That conclusion may be correct or not, but multiple years of experience with miniature donkeys gave the Huffs sufficient experience to disagree with their expert's approach and try a different path to profit.

Mikhail, Samer, et ux. v. Comm

The second factor relevant to this case is the expertise of the taxpayers or their advisers. Taxpayers should not only familiarize themselves with the undertaking, but should also consult or employ an expert, if needed, for advice on how to make the operation profitable.

In this case, the taxpayers had no personal expertise, and did not make an effort to learn about the business end of the dog breeding operation. The petitioners consulted Dr. Kennedy, read books, and attended seminars. However, these activities concerned the mechanics of dog breeding and not the economics of the activity. Although petitioners consulted an accountant (about bookkeeping) and an attorney (about whether to incorporate), they did not consult economic experts in the field prior to engaging in the activity. The taxpayers' failure to consult economic experts or develop an economic expertise themselves is another fact that indicates a lack of a profit motive in this case. See, e.g., Estate of Powers v. Commissioner, 46 T.C.M. (CCH) 1333, 1340 (1983), aff'd, 736 F.2d 826 (1st Cir. 1984); Steele, 41 T.C.M. (CCH) at 1096; Ballich, 37 T.C.M. (CCH) at 1851-45; Benz v. Commissioner, 63 T.C. 375, 385 (1974).

Petitioners had no experience in direct marketing activities or operating a small business before Dr. Mikhail was recruited as an Amway distributor in 2004. Petitioners obtained advice only from "upline" distributors -- persons who had a direct financial interest in the maximization of petitioners' sales volume, without regard to whether they would realize a profit. (NOTE: I thought it was kind of weird they were so dismissive of sales volume since an increase would seem to increase the chance of profit)

Estate of Power v. C.I.R

Although meticulous records were kept and Mrs. Power was well advised in financial matters by her attorney and Susan Annis, the court found that the principal objective was to enable Mrs. Power to continue her horse breeding operation on a smaller scale without incurring unduly burdensome costs, not to turn the operation around and produce a profit.

To be honest I've never been involved in a challenge regarding profit motive or trade or business disallowance but I thought some of this knowledge might help me when talking to clients to better ensure that remains the case, thought I would share.

Gotta go take care.
 

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