Paul L. Caron

Monday, April 22, 2019

Lesson From The Tax Court: Distinguishing Investment From Business Activity

The U.S. economy rests in no small part on capital allocation decisions made by a panoply of private participants.  Adam Smith explained in The Wealth of Nations why such a system “handily” beats all the others.  These individualized decisions find their practical expression in the buying and selling of “stock” of corporations on the “stock” market. 

Since 1921 Congress has supported this mode of capital formation by taxing income derived from capital at a lower rate than income from labor.  I blogged about this huge tax subsidy in “The Tax Lawyer’s Wedding Toast” last year.  Curiously, however, Congress did not permit deductions for the expenses of managing stock market investments until it enacted what is now §212(1) in the Revenue Act of 1942.  Until then, while taxpayers could deduct the ordinary and necessary expenses associated with trade or business activity (§162), they could not take parallel deductions for expenses associated with the investment of capital. 

Section 212(1) is the fix: it permits the same deductions as §162 for activities that are not a trade or business but are still for “the production or collection of income.”  

Investment expenses are still, however, disfavored by the deduction hierarchy created by §62.  If a taxpayer can hook expenses to a trade or business (or a §212(2) rental real estate), then §62 permits the deductions above the line.  But if the expenses relate only to an investment activity, then while §212(1) allows the same deductions, they must be taken below the line.  Bad: that means they fight against the standard deduction.  Worse: since they are not mentioned in §67(b), they are subject to a 2% floor.  Worst: starting in 2018 such deductions get sucked into the black hole of the recently enacted §67(g).  That section completely disallows miscellaneous itemized deductions.  You can think of it as 100% floor.  Yuck. 

The deduction hierarchy makes it important to know when an activity is a trade or business or mere investment.  In Ames D. Ray v. Commissioner, T.C. Memo. 2019-36 (Apr. 15, 2019), Judge Nega teaches a nice lesson about the difference.  Mr. Ray argued that he was entitled to deduct certain legal expenses, relating to three lawsuits, under §162.  He was not successful.  Judge Nega, however, allowed Mr. Ray the deduction under §212.  To see why, dive below the fold.

Congress could choose to tax the gross income from a trade or business without allowing deductions.  Congress has actually done that for some types of businesses, such as those involving marijuana.  See §280E (discussed in this post from last year).

From the start of the income tax, however, Congress has let taxpayers to deduct all the ordinary and necessary expenses paid or incurred in carrying on their trade or business.  §162.  The question soon arose:  What is a trade or business?  The two key cases on this subject remain Higgins and Groetzinger

The Law:  No Rule, Just Circumstance

In Higgins v. Commissioner, 312 U.S. 212 (1941), the Supreme Court refused to allow a taxpayer deductions for his costs of managing his capital investments.  Mr. Higgins owned New York City real estate worth some $10 million in the early 1930’s.  He also owned some $26 million in securities.  He lived in Paris.  To manage his financial affairs, he rented an office in Manhattan, employing four people.  Higgins closely supervised the real estate activities (thanks to those modern technologies the telegraph and telephone).  In contrast, he had little to do with his investments.  His securities were purchased by the U.S. Trust Company based on his generalized instructions (buy long and hold).  The only work the NY office had to do for the investments was receive and keep track of the certificates, interest and dividends sent there.  But the employees worked hard on managing his real estate.  The Tax Court found as a matter of fact that 2/3rds of the NY office time and effort was spent on the real estate activities and only 1/3 was spent on receiving and accounting for the investments. 

Mr. Higgins attempted to deduct all of his expenses related to the NY office, including the rent, salaries, utilities, supplies.  The Tax Court, sustained by the 2nd Circuit Court of Appeals and by the Supreme Court, held that he could deduct the expenses attributable to the real estate activity because that was a trade or business.  But he could not deduct the expenses attributable to the investment activity because it was not a trade or business.  Hey, 2/3rd of a loaf is better than none.

But Higgins wanted it all.  He argued that his "continuity, constant repetition, regularity and extent" of effort in managing his investments differentiated his activities from regular Joes and Janes who just dabbled in the markets.  This idea of regular and continuous activity was in contrast to the traditional idea approved just the prior term, that “carrying on any trade or business, within the contemplation of § 23(a), involves holding one's self out to others as engaged in the selling of goods or services.”)(internal quotes omitted).  Deputy v. du Pont, 308 U.S. 488, 499 (1940)(Frankfurter, J., concurring). 

Higgins had some decent case authority for his position, but the Supreme Court rejected those as “certain rulings of less dignity” (p. 215) and noted that there was no “fixed administrative construction” that would overturn the IRS and Tax Court’s conclusion that his activity was not a trade or business.  That conclusion was “adequately supported by this record, and rests upon a conception of carrying on business similar to that expressed by this Court for an antecedent section.” (p. 218).  In short, said the Court: “no matter how large the estate or how continuous or extended the work required may be, such facts are not sufficient, as a matter of law” to make the activity a trade or business.   Congress quickly reacted and enacted what is now §212(1) in 1942.  Mr. Eugene Higgins did not get to enjoy his victory for long.  He died in 1948.

Forty-five years later the Supreme Court seemingly adopted the very idea that it rejected in Higgins.  In Commissioner v. Groetzinger, 480 U.S. 23 (1987), the Supreme Court said: “We accept the fact that, to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity, and that the taxpayer's primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify.”  The Groetzinger Court explicitly rejected Justice Frankfurter’s idea that a trade or business must involve the public offering of goods or services.

That was a lucky result for Robert P. Groetzinger, an unemployed marketer who went all-in on dog racing in 1978, devoting 60-80 hours per week “studying racing forms, programs and other materials.”  He won over $70,000 but lost about $72,000, according to the Tax Court opinion.  Per §165(d) his deduction for gambling losses was limited to $70,000.  Worse, however, the AMT rules at the time provided that a portion of that $70,000 loss deduction would be ignored for AMT purposes as an item of tax preference if it was not related to a trade or business.  So Mr. Groetzinger really wanted his gambling activity to be a trade or business.  He made the Higgins argument that gosh, he really worked hard at it!  His testimony impressed the Tax Court.  And it worked for the Supreme Court: “we conclude that, if one's gambling activity is pursued full-time, in good faith, and with regularity, to the production of income for a livelihood, and is not a mere hobby, it is a trade or business within the meaning of the statutes with which we are here concerned. Respondent Groetzinger satisfied that test in 1978. Constant and large-scale effort on his part was made. Skill was required and was applied. He did what he did for a livelihood, though with a less-than-successful result. This was not a hobby or a passing fancy or an occasional bet for amusement.”  480 U.S. at 35-36.

The Groetzinger Court explicitly refused to overrule Higgins: “We do not overrule or cut back on the Court's holding in Higgins,” it said.  Why?  Because each case turns on its facts.  “Higgins,” said the Court, “with its stress on examining the facts in each case, affords no readily helpful standard, in the usual sense, with which to decide the present case and others similar to it. The Court's cases, thus, give us results, but little general guidance.”  480 U.S. at 36.

You can say the same about Groetzinger.  It gives no really helpful general rule to use.  Indeed, the Court deliberately left the resolution of future cases to “the facts in each case,” out of a “concern that an attempt judicially to formulate and impose a test for all situations would be counterproductive, unhelpful, and even somewhat precarious for the overall integrity of the Code.”  480 U.S. at 36.

You can understand the Groetzinger concern simply by comparing the differing issues in Higgins and in Groetzinger.  While both addressed the question of whether an activity was a trade or business, they did so in different legal contexts.  Higgins involved the question of business activity v. investment activity.  Groetzinger addressed the tension between business activity v. hobby activity.   

Courts keep trying to decide what facts convert an investing activity into a trade or business activity.  Whatever approach one takes, it had better be able to explain the different results in Higgins and Groetzinger

Some look at short-term vs. long-term profit-seeking.  The Federal Circuit held that in order to be in a business, “a taxpayer's activities must be directed to short-term trading, not the long-term holding of investments, and income must be principally derived from the sale of securities rather than from dividends and interest paid on those securities.”  That was an important factor for the Federal Circuit in Moller v. United States, 721 F.2d 810, 813 (Fed. Cir. 1983)  The Tax Court follows the Moller idea.  See Nelson v. Commissioner, T.C. Memo. 2013-259.

That idea in Moller works to explain the different results in Higgins and Groetzinger.  Mr. Higgins was a buy-and-hold kinda guy.  Mr. Groetzinger was definitely focused on short term results! 

Today’s case, I think, offers a different idea, although related.  Look at what Mr. Groetzinger did that Mr. Higgins did not do.  Mr. Groetzinger picked the winners and losers himself.  Sure, he did that at the racetrack, but one could as well do that in the stock or commodities markets.  In contrast, Mr. Higgins just delegated.  He paid someone else---the U.S. Trust Company---to pick the winners and losers and send him the winnings.  Notice how “[s]kill was required and was applied” for Mr. Groetzinger but not for Mr. Higgins. 

I see this idea in last week’s case, Ray v. Commissioner.  It's another way of reconciling Higgins and Groetzinger.

Facts of the Case

Mr. Ray had a tangled personal and financial relationship with Ms. Christina I. Ray.  They met as graduate physics students.  Neither became a rocket scientist.  Mr. Ray pursued a career in computer programming and Ms. Ray pursued a career in trading securities.  She has written several books on the subject and has adjuncted at Georgetown U.  Married for five years in the 1970’s they continued to mingle personal and financial lives for some 15 years after their divorce in 1977.  

Over time they grew further apart, with Mr. Ray moving to Florida in 1992.  Their financial entanglements, however, continued.  Judge Nega writes that in 1993 Ms. Ray convinced Mr. Ray to give her approximately $350,000 “to trade commodities futures and options using market theories and trading methods she had developed and wished to develop further.”   Mr. Ray did this, Judge Nega found, partly because of “his desire to help Ms. Ray develop her theories and methods” but mostly “because he believed it would yield significant profits and returns on his investment.”

Ms. Ray went right to work, actively trading Mr. Ray’s money.  She appeared to have been focused on short-term trading.  She also apparently lost all of Mr. Ray’s money in a few months. 

Over time he got mad.  He sued her.  Over and over and over again.  Three lawsuits, all in state court.  The first suit had two claims, totaling $975,000: (1) a claim for $590,000 for various alleged financial damages she had caused by not repaying personal loans (60.5% of the total claims); and (2) a claim for $385,000, comprising the loss of his $350,000 plus some $35,000 in interest ($39.5% of total claims).  The second suit was a fraudulent conveyance suit, alleging that Ms. Ray was moving assets to avoid paying what she was going to owe him in the first suit.  The second suit was dismissed in 2013.  Undeterred Mr. Ray filed a second fraudulent conveyance suit in 2014.   It was also dismissed.

On his 2014 return, Mr. Ray deducted some $77,000 in legal fees associated with the first lawsuit and $151,500 in legal expenses associated with the third suit.  The IRS said all the legal expenses related to purely personal lawsuits.  So it denied deduction of the expenses per §262.  Mr. Ray said all the expenses related to his computer programming business. 

Judge Nega held that neither party was correct.  He agreed with the IRS that none of the suits related to a trade or business, but he concluded that part of the suits related to investment activity and so used the Cohan rule (which I explained in this past post) to find that 39.5% the legal expenses related to the part of Mr. Ray’s claim against Ms. Ray for losing his $350,000 in her commodities futures trading scheme.  This seemed an eminently reasonable result and consistent with what the Supreme Court did in Higgins.

Lesson: It’s Not What You Do, It’s How You Do It

I want to focus here on Mr. Ray’s loss of the $350,000 he gave Ms. Ray for her trading experiments.  That’s the part that Judge Nega found was an investment activity and not a trade or business activity.  The reason why, I think, helps us navigate between the facts of Higgins and the facts of Groetzinger. 

Mr. Ray’s first said his lawsuit was connected to his computer programming business because that’s where he got the $350,000 to invest.   Er, no.  Judge Nega dismissed that idea in a footnote: “The mere fact that petitioner had earned income from working in the computing programming industry and then invested that money in another venture does not mean that the latter automatically a computer programming business.” Well, yeah. 

So that leaves the "continuous, regular, and substantial" test.  The key fact for Judge Nega seemed to be that Mr. Ray did not do anything except give his money to Ms. Ray.  She did all the continuous, regular and substantial trading.  “The facts establish that the purported business was in actuality Ms. Ray’s management of a hedge fund and that petitioner’s involvement in her management of that fund extended no further than his initial investment.”

Notice that this is a different key fact that the idea of short-term trading vs. buy-and-hold investment that the Federal Circuit used in Moller and the Tax Court used in Nelson.  If you simply look at the investment activity, Mr. Ray’s investment activity looks a lot more like Groetzinger and a lot less like Higgins.  It was focused on short-term gains and not long-term results.   That's why Ms. Ray burned through his money in a few months.

But Mr. Ray was actually more like Mr. Higgins than Mr. Groetzinger.  Someone else make all his  investment decisions.  He just sat back and held out his hand for the profits.  He did not devote significant time, effort, or skill in trying to pick the winners and losers. 

Back in 1994 I started investing, for both short and long-term goals.  I quickly determined that it would take way too much time, effort, and skill for me to learn how to pick stocks.  I decided I would rather read, watch movies, play games with my kids.   So I've been an index fund investor ever since.  I'm like Mr. Higgins: I just make basic asset allocation decisions and then buy and hold (readjusting periodically to keep the proper asset mix).

Other folks may make different choices.  The choice to actively manage ones investments is, I would argue, a significant fact in deciding whether a taxpayer is engaged in more than just an investment activity.  If my client was a person who devoted regular and continuous time and effort random walks down Wall Street, picking winners, monitoring results, altering strategies and asset mixes, investigating the myriad types of financial instruments one can get involved in, and deciding when and how long to jump and out of various markets, I would think that way of investing supports treating it as a trade or business.   That client would be like Mr. Groetzinger, even if the objectives were both short and long-term.

To me, the facts about how a taxpayer conducts their investment activity are more important than whether they are pursuing long-term or short-term results.  At least that is the lesson I take from this case.  But, as usual, I welcome other thoughts and corrections of error in the comments section.  

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

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Correction: I was mistaken to say that one can think of 67(g) as a 100% floor. That suggests that miscellaneous itemized deductions that exceed 100 of one's AGI would be deductible. That's wrong. It's just a total disallowance rule.

Posted by: bryan camp | Apr 22, 2019 10:08:51 AM

@Scott: I agree with you that long-term v. short-term is a relevant factor. I think what courts look for is whether the taxpayer is making his or her livelihood from the activity. Most of us work for our money, but if a taxpayer has so much money that it works for him or her, then the taxpayer's active involvement in managing how that money produces the stream of income he or she lives on should, IMHO, support characterizing that activity as a T or B. And that would be true regardless of whether the taxpayer's income stream results from "long-term" or "short-term" gains from capital. It's definitely a fuzzy area, but the very uncertainty that obscures any bright-line rule also creates room for imaginative arguments. My friends (both of them) tell me I sometimes have too much imagination. So it's probably a good thing I remain a harmless blogger.

Posted by: bryan camp | Apr 22, 2019 10:01:29 AM

Don't you think that a taxpayer who wants to deduct business expenses as a trader and does mostly long-term trades would have a hard time qualify even considering how they conduct the activity?

Posted by: Scott Estill | Apr 22, 2019 8:53:42 AM