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Monday, April 23, 2018

Lesson From The Tax Court: It's Still An Adversarial Process

Tax Court (2017)Several features of the Tax Court make it a unique institution in U.S. law.  For example, no other court has (or needs) the Golsen rule. Here’s a post where I explain why.  And no other federal court uses the Tax Court’s quasi-en banc process. Kandyce Korotky over at Procedurally Taxing has a nice post here describing how that process sometimes produces opinions where more judges join the concurrence than the opinion of the Court.

But the Tax Court still hews to that greatest feature of the U.S. legal tradition: the adversarial process, where each side takes responsibility for presenting its own case and the Court simply judges between the cases presented. That is the lesson I see in last week’s decision in Aaron Keith Nicholson v. Commissioner, T.C. Summary Opinion 2018-24 where the taxpayer was representing himself and the IRS was represented by not one but FIVE attorneys of record. Really. I think the case should have been a lesson about the hobby loss rules, but it turns into a lesson that tax litigation rests on an adversarial process where the parties’ concessions, no matter how lame they appear, will bind them.   This is true even in the small case procedure. Here, it benefitted the taxpayer.

Mr. Nicholson was employed as an engineer during the years at issue, 2013 and 2014. He told Judge Guy that he found his work stressful. Writes Judge Guy: “To reduce stress, petitioner decided to develop his talents as a musician...” O.k. you know where this is going. But if you want another clue, here’s more from the opinion: “Petitioner testified that he is more creative and productive as a musician when he is happy and that he enhanced his artistic creativity and productivity by dining out with his children, engaging in recreational pursuits such as bowling, hiking and camping, and traveling to new destinations.” I confess I actually snickered when I read that because I was sure I knew where the case was going.

I was wrong.

All of that fun stuff cost money---let’s call them “artistic enhancement expenses”---and, yes, Mr. Nicholson attempted to deduct those expenses on the three Schedule C’s that he filed in 2013 and six (!) Schedule C’s that he filed in 2014. In addition to the artistic enhancement expenses, Mr. Nicholson also deducted $25,000 in 2013 for studio time to produce a CD and $2,800 in 2014 for the costs of creating 1,000 physical CD’s.

None of his activity produced gross receipts. Although Mr. Nicholson offered his music for sale to the public via the web, apparently no-one bought a CD or even a song because he reported zero income from his music activity in 2013 and 2014.

If you are thinking “hobby, hobby, hobby,” you and I think alike. As my 19 year old daughter is discovering, adulting (yes, that is now a verb) is stressful.  And so many of us engage in stress-relieving activities.  We call them hobbies.  While §162 permits the deduction of all the ordinary and necessary expenses related to the carrying on of a trade or business, §262 says that we cannot deduct personal expenses, such as the expenses of stress-relieving hobbies.

But sometimes our hobbies produce income. It would not be fair to force a taxpayer to report hobby income and at the same time deny deductions for the reasonable expenses paid to produce that income. That is when §183 comes in handy. It permits deduction of expenses that are ordinary and necessary to produce the hobby income but limits deductions to the amount of the hobby income. That is, while §183 helps taxpayers by allowing them to offset otherwise unallowable expenses against hobby income, it effectively denies taxpayers the ability offset net losses from the hobby against other income, such as income from your engineering job....   That’s why we generally call it the hobby loss rule.

As applied to Mr. Nicholson in 2013 and 2014, one quickly sees that even though the costs for studio time and CD production may have been ordinary and necessary for his hobby, the fact that his music activity produced no income means he should not be allowed any deductions because he had no income from the hobby.  He could only take deductions for a net loss if he could show that the activity was engaged in for profit and so claim the deductions under §162.

While this fact pattern fairly screams “hobby loss rule” to me, the IRS ignored that. Perhaps it was those nine Schedule C’s that did it, but for whatever reason, the IRS accepted that the music activity was a legit business activity. It instead disallowed the “artistic enhancement expenses” as non-deductible personal expenses. It disallowed the rest for Mr. Nicholson’s failure to substantiate the expenses. And so Mr. Nicholson went to Tax Court, drawing Judge Guy.   Representing himself, Mr. Nicholson was able to substantiate many of the bigger expenses, such as studio and CD production costs. 

Judge Guy’s opinion, however, appears skeptical that Mr. Nicholson’s activity was really a business. I say that because Judge Guy consistently refers to Mr. Nicholson’s “music-related activities” and not his “music business.” I also say that because Judge Guy recited zero facts that would support a finding of profit-motive and instead recited numerous facts that support the opposite conclusion. For example, Judge Guy reports that “Petitioner acknowledged that several receipts that he had included in this business records, including those for a baby carrier, children’s books, a stud- finder, and a chain saw rental, likely were not related to his music activities.”

Now it may well be that the facts we do not know make Mr. Nicholson’s activity a genuine profit-seeking activity. The lesson point here, however, is that it does not matter. In an adversarial system it’s not the job of the Court to create arguments for one side or another. It’s the job of each adversary. Here, for whatever reason the IRS did not challenge whether Mr. Nicholson’s activity was really a business. The IRS Office of Chief Counsel attorneys did not dispute that Mr. Nicholson’s activity was a trade or business activity such that §162 governed the outcome of the case.  The IRS instead proceeded on the theory that, yes indeedy, Mr. Nicholson ran a music business.  And the Court was not going to challenge a position that the IRS accepted, no matter how skeptical the Court might be.

Notice how the difference between this week’s lesson and last week’s lesson on getting lucky. Last week the taxpayer got lucky when what both sides had thought was an IRA distribution turned out not to be because of a prior year disqualified transaction. There, the Court spotted an issue addressed by neither party and had both sides brief it. This week, the taxpayer had taken an affirmative position that his music activity was a trade or business and the IRS did not dispute that position. The Court was not going to independently search for facts related to an issue neither side was contesting.  In an adversarial process, that’s just not the Court's job.

Coda 1: On the surface there may seem to some a David v. Goliath quality to this case because Mr. Nicholson was representing himself and he was opposed by five IRS Chief Counsel attorneys of record. And he walked away from Court preserving about half of his claimed expenses and being allowed the resulting offset against his engineering income. I cannot imagine five IRS attorneys working on this case together so I suspect that listing of five attorneys instead reflects this case file being passed around multiple times while it was pending in Tax Court. That might also account for the IRS’s failure to spot and argue the hobby loss rule. Just my speculation.

Coda 2: Mr. Nicholson did get hit with §6662(a) penalty for trying to deduct the “artistic enhancement expenses.” In an effort to escape the penalty, Mr. Nicholson tried the Turbo-Tax defense. Judge Guy was not buying it.

Coda 3: Speaking of buying, Mr. Nicholson’s music is still for sale on the web. If you want to give him some gross income for 2018, you can do that here. If you want to listen before you buy, here’s a YouTube link. And before Mr. Nicholson gets too excited about the IRS overlooking the hobby loss rule in 2013 and 2014, he should review the prior Lesson From The Tax Court: One Year At A Time.

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.

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