.You can put lipstick on a pig, but it’s still a pig. According to Wikipedia, that is a late 20th century update to an older expression "A hog in armour is still but a hog.” Both convey the same idea: superficial alterations do not change the essence of a thing.
Two recent cases from the Tax Court teach a tax version of that lesson: no matter how much you dress up a yacht in a business suit, it’s still a pleasure boat. First, in Carlos Langston and Pamela Langston v. Commissioner, T.C. Memo. 2019-19 (Mar. 21, 2019) (Judge Nega), we once again learn a lesson from the Langstons, the same taxpayers who tried to convince Judge Nega that they had converted their home into an income-producing asset. That was the subject of this prior lesson. Here, in the same case, they also tried to pass off a modest 58’ 2006 Meridian 580 yacht as a business asset. I say "modest" advisedly because the second case is Charles M. Steiner and Rhoda L. Steiner v. Commissioner, T. C. Memo 2019-25 (April 2, 2019)(Judge Ruwe) and it involves a decidedly immodest 155’ Super Yacht called “Triumphant Lady.” After the Steiners decided to sell that yacht they first tried to dress it up as a leasing venture to reduce their considerable carrying costs pending sale.
Turns out, size did not matter. Both taxpayers floundered on two of the several sharp shoals in the Tax Code that sink attempts to pass off pleasure boats as businesses. Taxpayers lured by the siren song of tax breaks should learn the lessons you will find below the fold.
Most folks buy yachts for personal reasons, generally for some combination of pleasure or status. Few souls say “hey, I think I’ll sink a boatload of money into a single yacht so I can make a bigger boatload of money leasing it out!” Sure, there are lots of companies that offer boat owners so-called “business” opportunities. But the typical sales pitch, at least of the websites I cruised, is all about helping boat owners reduce ownership costs, similar to the pitches for multi-level marketing schemes. For example, this website touted it’s fail-safe business plan as a way to give yacht owners “the ability to leverage small business tax advantages to offset the costs of ownership, not just charter income.” This other yacht business consulting website is a bit more straightforward: “Considering the information we have provided above, I hope it is clear that those who are in [the yacht leasing] business for profit (owning the vessel/s) will have a tough time against those who are essentially covering cost of ownership and therefore are running at a loss.”
As evidenced by simply the existence of these sites, optimistic and greedy taxpayers regularly try to pass off their yachts as business assets so they can deduct some or all of their non-trivial ownership costs against their other income. To do so, however, they must navigate around a shoal complex of tax statutes, including §183, §274, §280A, §280F, §465, and §469. The two up for discussion today: §183, and §274.
The taxpayers in each of these two cases took different tacks in trying to deduct their yacht expenses against other income. The Langstons had a legit business and argued that they were using their yacht in furtherance of that business. They failed to navigate around §274. In contrast, the Steiners argued that they had successfully converted their yacht from personal use to a for-profit business or investment use. But they got stuck on §183. Let's take a quick look at each provision.
Both §183 and §274 create rules that attempt to allow deduction for business activities but not for personal activities. Each operates to disallow expenses if those expenses are not sufficiently tied to a profit-making activity.
Section 183. This section permits deductions for expenses incurred in a taxpayer’s hobby. That’s nice. Less nice is that §183 denies deductions for expenses in excess of hobby income. Thus, by definition, a hobby cannot produce a net loss. In contrast, if a taxpayer’s activity is not a hobby but a business, the permitted deductions are not limited by §183 and if the taxpayer has a net loss from the activity, the taxpayer may deduct that loss against other income from other activities, subject to the at-risk rules in §465 and passive activity rules in §469, which are beyond the scope of today’s post.
To navigate around §183 a taxpayer must show they engaged in an activity to make a profit. The critical question that the IRS and the Courts ask is whether making a profit was the taxpayer’s "predominant, primary, or principal objective" for engaging in the activity. See e.g. Wolf v. Commissioner, 4 F.3d 709, 713 (9th Cir. 1993). This question about making a profit has nothing to do with the intensity of a taxpayer’s feelings about the activity or the esteem with which the taxpayer is held by others engaged in that activity. A group of golfers may include some who are professional and some who are hobbyists. They all want to win, and they all value their reputations. But only the ones who play golf for profit can avoid the restrictions of §183.
Section 183(d) helps taxpayers by creating a presumption that if the taxpayer actually made money from the activity for three of the five years before the tax year in question, then the taxpayer enjoys a presumption that the activity is not restricted by §183 for the tax year in question. Treas.Reg. 1.183-2 lists a bunch of factors that are designed to answer that basic question about the taxpayer’s primary objective for doing the activity. Judge Holmes gives a very useful rundown of how the Tax Court applies those factors in the recent case of Kurdziel v. Commissioner, T.C. Memo 2019-20, which I blogged about here.
Section 274. This section deals with the idea that it is really difficult to distinguish between business and pleasure for expenses that are “generally considered to constitute entertainment, amusement, or recreation.” §274(a)(1)(A).
Prior to 2018, taxpayers could deduct entertainment activity expenses if they were directly connected to the active conduct of a trade or business. But Congress changed that in the December 2017 tax reform legislation. Amending §274 to totally disallow entertainment expenses was bad news to sales forces everywhere, and to the golf courses and ballparks they used. The IRS has done its best to claw back something for taxpayers by allowing deductions for “meals” during the “entertainment” if the meals were purchased separately and met the other requirements for deduction in §274 (not lavish, properly substantiated, limited to 50% of cost). See Notice 2018-76. So the ball game tickets are no longer deductible but the hot dogs are.
Even before 2018, however, taxpayers could not deduct the expenses of entertainment “facilities.” And guess what? A yacht is an entertainment facility. Treas. Reg. 1.274-2(e)(2)(i). Nonetheless, if a taxpayer can prove that the yacht was used “primarily” in their trade or business, then they can deduct a proportionate amount of the expenses of owning the yacht that correspond to the business use. (e)(4). Those expenses include depreciation. But even if the taxpayer can prove the “primary” use in business, the taxpayer must still satisfy the enhanced substantiation requirements described in Treas. Reg. 1.274-5T.
Lesson from Langstons: Documentation Is Necessary
The Langstons owned and operated two marinas: Mastead Marina and Port Carlos both outside of Tulsa, near Ketchum, OK. They also owned a 55’ Meridian 580 yacht which they bought in 2011 for $246,000---way more than average home cost here in Lubbock of $131,000. Flyover country has some advantages!
For the 2012 and 2013 tax years the Langstons took depreciation deductions for the yacht of $140,000 and $36,000 respectively. The IRS disallowed the deductions and the Langstons protested to the Tax Court. They claimed that they used their yacht to enhance their marina businesses. Their only proof was their own testimony that they used the yacht “solely for business purposes” as their business office. Yeah, right. Judge Nega did not believe them, either. He pointed out that they offered no other witnesses to testify. They offered no records or documentary proof of the yacht’s business use. They did not even have a sign on the boat saying “Sales/Leasing Office.” What really sank their argument, however, was the RA’s testimony that when she had inspected the yacht, it was “littered with items indicative of personal use.”
Lesson from Steiners: You Gotta Prove Profit Motive
The Steiners did not own or operate any business related to yachting. Mr. Steiner was an extremely successful businessman who made a fortune in the electrical supply business. He and Mrs. Steiner were also very generous, giving over $1 million to the University of Pittsburgh. They also sure loved boating. Judge Ruwe explained that the Steiners were into boating “since the 1970’s and have owned several boats over the years.” They bought a big one in 2001, the “Triumphant Lady.” It cost them $4.6 million to buy---waaaay more than even the $871,000 average home cost in Manhattan, the most expensive market in the U.S.
The Steiners then sunk over $10 million more into the yacht to bring it up to snuff for a planned sail around the world. They employed a full-time Captain and crew that cost them over $25,000 each month in wages.
Alas, you know what the poet said about the best laid plans. Here, the Steiners’ health and finances took a downturn, so in 2010 they decided to sell the yacht. The year before they had listed the yacht for charters with an agent and they kept listing it for charter during the period it was up for sale. Their initial asking price of over $15 million proved too much for the market. Judge Ruwe's opinion says they sold it in 2012 for $4.4 million. It looks like they may have sold it to Judge Judy (?) who may have resold it in 2016 for $6.9 million. At any rate here's a 2016 listing for the yacht for $6.9 m.
During the three years that they listed the yacht for charter the Steiners kept good records of their expenses and they kept a separate bank account. They advertised the boat and actually secured a single charter. However, as Judge Ruew writes: “Petitioners did not have a formal business plan. There is no evidence that petitioners consulted charter industry experts about the profit potential other than charter brokerage companies that would earn a commission upon charter. *** The charter activity never produced a profit.”
When you have an activity that costs money but does not produce a profit, you have a hobby. Judge Ruwe’s opinion runs through the nine factors in Treas. Reg. 1.183-2 and concludes that only one favored the taxpayers: the Steiners derived no personal enjoyment from the yacht leasing activity. The biggest factors hurting them were: (a) the lack of any business plan, or attempts by Mr. Steiner to apply his business skills to the yacht leasing activity---he basically punted (yes, that is a nautical term too) to the hired Captain; and (b) the huge yearly losses, which they then used to shelter part of their massive income of $5.4 million in 2011 and $11 million in 2012.
Judge Ruwe concludes: “it appears that petitioners’ primary objective was to partially offset the significant fixed costs of maintaining the yacht so that it could be sold after they stopped using it for personal purposes. And petitioner’ objective was to offset their significant income with these fixed costs.”
Coda: Folks, if you really want to get into a successful yachting business, you must find a way to provides goods or services to the rich folk who can afford them! Perhaps buy a fleet to charter. Or provide services such as this example of a successful yacht-related business.
Langston Coda: It looks like the Langstons sold Port Carlos in 2013 and Masthead Marina in 2017.
Steiner Coda: Peter Reilly gives his take on the case here. Even if the Steiner's avoided §183, they would still run up against §469. Section 469(c)(2) says that a passive activity includes any rental activity. So the Steiners would not have been able to deduct their passive activity losses against their active income. And the Steiners made way to much money to benefit from the limited exception for losses from rental real estate activities, if indeed yacht leasing would even qualify as “real estate rental.” Section 469, however, would at least allow the Steiners to carry forward their passive activity losses and use them up when they sold the yacht.
Bryan Camp is the George H. Mahon Professor of Law at the land-locked Texas Tech University School of Law