For small businesses, losing money can mean losing tax deductions
Not all entrepreneurs running a business manage to turn a profit year-in, year-out.
But those that continuously operate at a loss may be classified as a hobby by the IRS – and lose the ability to deduct the losses from their taxes.
For example, the widow of a country music producer who continued to operate, at a loss, an establishment to encourage songwriters was not able to deduct her losses in excess of her income from the activity.
If an activity generates a profit, a taxpayer may deduct the expenses of the activity. But under the “hobby loss” rule of code Section 183(b), if the activity is not engaged in to make a profit, expenses of the activity may offset any income from the activity itself but may not be deducted against other income.
Joy Ford, a former country music recording artist, was the widow of Sherman Ford, a country music producer and record company owner. Together they purchased the Bell Cove Club, a small lakeside music venue in Hendersonville, Tennessee. Their intention was that Bell Cove would become a venue where songwriters could have their songs performed for talent scouts, agents and record producers. Many well-known artists have performed at Bell Cove, and it is known for furthering the careers of emerging songwriters.
After Sherman’s death, Joy continued to operate Bell Cove, featuring live country music on Friday and Saturday nights. Joy selected the performing artists, devoted most of her time to Bell Cove, and paid all of its expenses. She charged a $5 admission fee and a nominal amount for snacks and beverages and received annual gross receipts of $17,006, $14,156, and $13,581 in the years 2012, 2013 and 2014. Bell Cove’s expenses consistently exceeded the amount she received from admission fees and snack and beverage sales. Her expenses for those same years relating to taxes, liability insurance, utilities, repairs, license fees and other miscellaneous expenses totaled $37,332, $75,779 and $92,769, respectively.
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While she considered ways to make Bell Cove profitable, including producing a television show based on the club, or turning it into seafood restaurant, none of the ideas suggested to her by business experts advanced beyond initial discussions. She reported losses for the three years in question totaling over $200,000 and net operating loss deductions for 2012 and 2013.
The IRS determined that Joy did not operate Bell Cove for profit, had failed to substantiate the NOL deductions, and was liable for the section 6662(a) accuracy-related penalties for negligence.
The Tax Court sustained the IRS disallowance of her deductions, finding that Joy did not have the requisite intent to make a profit.
“She had no expertise in club ownership, maintained inadequate records, disregarded expert business advice, nonchalantly accepted Bell Cove’s perpetual losses, and made no attempt to reduce expenses, increase revenue, or improve Bell Cove’s overall performance,” said the court. Although she “earnestly devoted time and energy to Bell Cove,” the court found that she was “primarily motivated by personal pleasure, not profit, and simply used the club’s losses to offset her trust and capital gain income.”
The court also sustained the IRS on the issue of NOL deductions, since they were not substantiated or addressed at trial. However, the court did not sustain the section 6662(a) accuracy-related penalties. The IRS failed to present evidence that the penalties were “personally approved (in writing) by the immediate supervisor of the individual making such determination.”