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Internal Revenue Code

Hobby Loss: Not just horse racing

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Some activities have been associated with the idea of a tax shelter for wealthy taxpayer.  These are commonly understood to be in danger of challenge from the IRS for hobby loss disallowance.  However, the rules apply to any activity that does not generate a profit for several years in a row.

Although originally adopted primarily to curtail the deduction of farm hobby losses,  § 183 has been applied to a wide variety of activities including: acting, art work, writing, auto racing, gunsmithing, practicing law, making movies and videotapes, operating a talent agency, dog breeding, horse breeding, cattle ranching, farming, operating a bed and breakfast, aircraft rentals, boat chartering, boat racing, fishing, golfing, venture capitalization, used car sales, mining and drilling, sound recordings, Amway distributorships, tax shelters, and drag racing.

In addition to the foregoing, the IRS has also identified photography, stamp collecting, bowling, gambling, motocross racing, horse racing , artists, entertainers, and craft sales as possible § 183 activities.

Delaware Statutory Trusts tax issues

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Question:  How can a US taxpayer (“Sponsor” or “Developer”) obtain investors (including 1031 investors) in an investment while maintaining control of the investment?

Answer:  use a Delaware Statutory Trust (“DST”).  The choice involves some restrictions but it can work well in the right situation.

Limited Liability Entity.  A DST formed for investment purposes is recognized by the State of Delaware as a separate legal entity.  It issues certificates to its beneficiaries (aka owners).  Under Delaware law, it may sue or be sued and beneficial owners have limited liability like the shareholders of a corporation.  A creditor of an owner may not assert a claim against the assets of the DST.  The interests in the DST are freely transferable; but, may not be publicly traded on an established security market.  The DST may not act as an agent of the owners.

Owner Control.  The trustee is severely restricted from exercising control over the assets of the trust.  The trustee may not have the power to vary the investments of the trust including a managerial power to buy or sell assets to take advantage of variations in the market to improve the investment of the investors.  In effect, the trustee may not carry on a profit making enterprise.  But, the trustee can own as an investment an entity that carries on a profit making enterprise.  Rev Rul 2004-33.  The trustee is generally required to distribute all of the net income quarterly to the owners.  Owner beneficiaries are also strictly prohibited from exercising any control over the assets of the trust.

1031 Exchange.  An owner can exchange its interest in any real estate investment for a certificate in a DST.

Analysis:

Tax Classification of Delaware Statutory Trust.

The DST must be carefully created to avoid being treated for tax purposes as either an agent of the owners or a partnership with the owners.  For US tax purposes, the DST is either a trust or a business entity.  Reg 301.7701-4(c)(1).   The key fact is whether the trustee of the DST has the power under the trust agreement to vary the investments of the trust.

In order to not be held not to be engaged in a profit making business, the DST should only receive assets and assume liabilities of known unvarying amounts. For example, a shopping center that entered into a 10 year lease with a tenant, and was subject to a nonrecourse loan with a term of at least 10 years could be validly owned by a DST with a 10 year term.  The trust agreement should provide that the trustee’s activities are limited to the collection and distribution of income.The trustee may not exchange the shopping center for other property, purchase assets other than short-term investments such as the demand bank account or short-term money market account, or except additional contributions of assets (including money) to the DST.

Exchange of Real Property for DST interests under Section 1031.

The owners are treated as grantors of the DST under regulation 1.671 – 2(e) (3) when they acquire their interests in the trust. Because they have the right to distributions of all trust income attributable to their undivided fractional interest in the trust, the owners are each treated, by reason of section 677 as the owner of an undivided portion of the trust and all income deductions and credits attributable to that portion are included by each of them under section 671 in computing their taxable income.

The exchange of real property interests for certificate of ownership of a portion of DST is treated, for tax purposes, as an exchange of the real property interests for a portion of the underlying real property assets of the DST. Section 1031 (a) (2) (E).   So long as all of the requirements of section 1031 a satisfied the exchange of real property for an interest in the DST will qualify for nonrecognition of gain or loss under section 1031. The same result would occur if the owners exchanged real property with a third-party and immediately formed the DST by conceding their interests in the real property received.

Caveat.

The DST will be treated for tax purposes as business entity (either partnership, corporation or sole proprietorship) if trustee has additional powers under the trust agreement such as the power to:
1. Dispose of the real estate and acquire new property;
2. Renegotiate the lease with the current tenant or enter into leases with tenants other than the current tenant;
3. Renegotiate or refinance the obligations used purchase the real estate;
4. Invest cash received to profit from market fluctuations;
5. Make more than minor nonstructural modifications to the real estate not required by law;

Voting and Non-Voting S corp shares

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Question: Can an S-corp have different types of shares? Can a shares voting restriction be accomplished by agreement between the parties and still all have the same type of shares, or can this only be done in a c-corp with different types of shares?

Answer:  The answer is:  while an S corp can only have one class of stock; the one class can be divided into subclasses of voting and nonvoting shares or with voting restricted as you described.

Treasury Regulation 1.1361-1. “[d]ifferences in voting rights among shares of stock of a corporation are disregarded in determining whether a corporation has more than one class of stock.”   Thus, an S corporation “may have voting and nonvoting common stock, a class of stock that may vote only on certain issues, irrevocable proxy agreements, or groups of shares that differ with respect to rights to elect members of the board of directors.”

Avoid UK double tax trap in US LLC

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The United Kingdom taxes its residents on their income from interests owned in the United States.  This includes US citizens residing in the UK.

The US also taxes the income of its residents on their world wide income.  Without the relief from the US/UK tax treaty both countries would tax this income and it would be subject to double tax.  Fortunately, the US/UK tax treaty mitigates this double tax in most situations.

One big exception is in the tax treatment of a US limited liability company (“LLC”).  The US taxes this entity as a partnership and allows the income to pass through to the owners without an entity level tax.  The UK taxes this entity as a corporation and imposes an entity level income tax.  The result is that the unwary owner can be double taxed on the income from the LLC (once by the UK on the entity and again by the US on the owner’s income).

One good solution is to use a limited partnership (“LP”) in the US.  Both the US and the UK treat LP as a flow through entity and tax its income only in the hands of the owner.  No double taxation.

This works well if you use the LP from the beginning.  However, it can also help if the LLC is in operation and the double taxation problem discovered.  In most cases, the LLC can convert from the LLC to the LP without adverse US tax effects to the owners.  See IRS Rev Rule 84-52.

Hobby Loss: Profit Motive

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The fact that a taxpayer spends his personal time cultivating an activity may be indicative of profit intent.  Peacock v. Commissioner, T.C. Memo 2002-122.  Especially, where the activity in question has no substantial personal or recreational aspects.    Ibid.  Moreover, an individual’s withdrawal from another occupation to devote his time to the activity in question may also indicate a profit motive.   Reg. 1.183-2(b)(3); Burleson v. Commissioner, T.C. Memo 1983-570

Hobby Loss: Taxpayer intent

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The taxpayer’s intent to engage in a activity for profit is essential to enable the taxpayer to take deductions for the activity (including deductions in excess of the revenue from the activity).

The taxpayer’s intent is a question of fact.

The threshold inquiry in determining whether an activity is a trade or business or is carried on for the production of income is whether the activity is engaged in for the primary purpose and dominant hope and intent of realizing a profit.  Hayden v. Commissioner, 889 F.2d 1548, 1552 (6th Cir. 1989), aff’g, T.C. Memo 1988-310.

The taxpayer has the burden of proof with respect to proving the requisite profit motive.

Profit means economic profit without regard to tax savings.

An activity is engaged in for profit if the taxpayer entertained an actual and honest, even though unreasonable or unrealistic, profit objective in engaging in the activity.  Campbell v. Commissioner, 868 F.2d 833, 836 (6th Cir. 1989), aff’g, in part, rev’g in part and rem’g, T.C. Memo 1986-569.

IRS regulation 26 CFR 1.183-2, “Activity not engaged in for profit” https://www.law.cornell.edu/cfr/text/26/1.183-2 sets forth the IRS position on the general requirements for motive and nine (9) relevant factors for determining profit motive:

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.

IRS audit guidelines provide for examiners to address each of the foregoing nine factors in a Hobby Loss situation. IRC § 183: Activities Not Engaged in For Profit (ATG) (Audit Guide Rev. 6/09).

The Committee Report for the Tax Reform Act of 1969 (the enabling act for IRC 183) states,

although a reasonable expectation of profit is not to be required, the facts and circumstances (without regard to the taxpayer’s subjective intent) would have to indicate that the taxpayer entered the activity, or continued the activity, with the objective of making a profit.