In: Accounting
John and Kathy Brown have just been audited and the IRS agent disallowed the business loss they claimed in 2015. The agent asserted that the activity was a hobby, not a business.
John and Kathy live in Rochester, New York, near Lake Ontario. Kathy is a CPA, and John was formerly employed by an insurance firm. John’s firm moved in 2006 and John resolved not to move to the firm’s new location. Instead of seeking other employment John felt he could supplement his income by using his fishing expertise. He had been an avid fisherman for 15 years, and he owned a large Chris-Craft fly-bridge that he chartered to paying parties.
In 2012, Kathy and John developed a business plan, established bank account for the charter activities, developed a bookkeeping system, and acquired insurance to cover the boat and the passengers. John fulfilled all the requirements to receive a U.S. Coast Guard operating license, a New York sport trolling license, and a seller’s permit. These licenses and permits were necessary to legally operate a charter boat. The first year of their activity was 2012.
John advertised in local papers and regional sport fishing magazines. He usually had three or four half-day paying parties each week. John spent at least one day maintaining and repairing his boat. Kathy usually accompanied John on charters three or four times each year.
John’s charter activity was unprofitable the first two years. In 2014, John and Kathy restructured the activity to improve profitability. The restructuring included increasing advertising, participating in outdoor shows, an negotiating small contracts with local businesses. After the restructuring, the activity provided a small profit in 2012 and 2013.
In 2015, John started working with another insurance company in the area on a full-time basis. Even though he returned to the insurance business, John normally took two paying parties and one nonpaying, promotional party each week throughout the fishing season. John’s costs unexpectedly increased and he lost $8,000 in the activity during 2015. John and Kathy deducted the entire loss on Schedule C of their 2015 tax return.
Required: John and Kathy come to you seeking advice. Prepare a memo recommending what position they should take with the IRS regarding the fishing charter activity and why.
13th March 2018
To John and Katy
Sub: Position with IRS with regards to deduction of expenses
Considering the facts of the case I would recommend you to file a form 5213 with the IRS. This form should be filed for the year 2015. Form 5213 is used for the purpose of postponing an IRS determination as to whether the presumption applies that an activity is engaged in for profit (or not). As per IRS criteria an activity is presumed to be engaged in for profit (and not a hobby) if the activity is profitable in three out of the five consecutive years. Use of form 5213 will enable you to have the IRS wait until the first five years are up before examining the profitability of your business. This form is to be filed within three years of the due date of the return for your first year in business.
Secondly you should provide IRS with the facts associated with your activities to prove that the time and effort being put by you clearly indicates an intention to generate profit. John can also prove that he has an extensive knowledge (considering his fishing expertise) that is needed to carry on this activity as a successful business.
When you are able to prove the above mentioned points and present the IRS with the facts and figures then the onus will shift to IRS and they will now have to prove, based on the facts, figures and circumstances, whether this activity will be considered as a business activity or a hobby.