Today's Lesson is an appropriate one for my 200th post. While the line separating my 199th from my 201st post is not big—not a great divide—the line does make visible a degree of effort and consistency that might otherwise be obscure. So, yeah, I'm kinda proud about crossing this line.
The concept of Adjusted Gross Income (AGI) also creates a line, one that confuses my students enormously. They have trouble understanding that the ability to take a deduction is affected not simply by the statute that authorizes the deduction but also by the statutes that tell you where to take the deduction in the process of calculating taxable income. And not only does the concept of AGI create a line—dividing deductions taken above the line from those taken below the line—it sometimes creates a great divide.
In Carl L. Gregory and Leila Gregory v. Commissioner, T.C. Memo. 2021-115 (Sept. 29, 2021)(Judge Jones), the taxpayer’s lawyers had the same trouble my students have. The case teaches a graphic lesson on the great divide that can exist between treatment of deductions taken above the line and those taken below, not to mention the great divide between the really rich and the rest of us. There, the taxpayers were unable to deduct a penny their yacht hobby expenses. While §183 allowed over $340,000 of deductions, this amount did not exceed 2% of the Gregorys' AGI. Wow. That fact at least explains why they may have thought it a good idea to pay attorneys to argue that the expenses went above the line. It does not explain why the attorneys did not advise that such an argument was groundless, bordering on frivolous. Details below the fold.
The “line” is created by a concept called “Adjusted Gross Income” (AGI). It was created in 1944 as a result of the Congressional decision to create a standard deduction. Let’s look at that first, then we will look at how that simple line became a great divide in 1986.
Law: Creation of The Line in 1944
To understand the law, you must first understand the history. When Congress re-created the income tax in 1913, the tax was designed to hit only the upper echelons of taxpayers. The rich really were different and not only in the way F. Scott Fitzgerald described. The rich were different because they had to pay taxes! At that time the Tax Code did not contain the concept of a standard deduction. Every deduction—whether business or non-business—had to be itemized and substantiated by the taxpayer.
Before 1944, determining taxable income required two steps: determining gross income and then subtracting whatever deductions were allowed. Yes, there were also credits and surtaxes, etc., but the basic idea was a two-step process: Gross Income – Deductions = Taxable Income.
The need to finance World War II led Congress to massively expand the income tax to almost everyone. In doing so, Congress recognized that the rich were different in yet another respect: they were better able to keep receipts and keep track of their deductible expenses, not only for their business but for their non-business deductions, such as donations to charities. Congress was concerned that the rest of us poor schlubs could not do that. As a result, §9 of the Individual Tax Act of 1944, Pub. L. No. 78-315, 58 Stat. 231, 236, created the concept of the Standard Deduction. I cannot find a free link to the Act, but you can get a good sense of what Congress was trying to do in Henry Rottschader, "The Individual Income Tax Act of 1944," 29 Minn. L. Rev. 94 (1945). To do that it needed to create a new term of art: Adjusted Gross Income (AGI).
The concept was simple: all taxpayers most likely had various non-business expenses that various tax statutes authorized as deductions, such as personal interest, charitable donations, medical expenses, etc. Taxpayers should be able to deduct some standard amount in lieu of having to substantiate all those non-business deductions. Taxpayers whose various non-business deductions exceeded that standard allowance could still elect to itemize those deductions.
The term of art "adjusted gross income" was needed because the standard allowance was to be calculated as a percentage of gross income after accounting for business deductions. The House Ways and Means Committee summed it up nicely this way:
“Generally speaking the standard deduction is a device to allow every taxpayer, regardless of his source of income, approximately 10 percent of his adjusted gross income (that is total income after business deductions) but not in excess of $500, in lieu of itemizing certain nonbusiness or personal deductions and credits. Any taxpayer may, if he chooses, itemize his actual deductions.” H. Rep. 78-1365 at 9. See also Alan L. Feld, Fairness in Rate Cuts in the Individual Income Tax, 68 Cornell L. Rev. 429 (1983).
The new term of art was thus statutorily defined as a taxpayer’s gross income minus a list of different types of deductions, all business-related. Interestingly, among the permitted deductions were “expenses of travel, meals, and lodging while away from home, paid or incurred by the taxpayer in connection with the performance by him of services as an employee.” Notice that was regardless of whether the employee was reimbursed.
Thus was “the line” created.
After 1944, determining taxable income now required three steps, not two: determining gross income, determining adjusted gross income, then determining taxable income (by either taking a percentage of the AGI as a standard deduction or electing to itemize deductions). The AGI was “the line” that separated those deductions taken from gross income (above the AGI line) and those taken from AGI (below the AGI line). You can see this in comparing the Form 1040 for 1943 and the Form 1040 for 1944. Nowhere in the 1943 form do you find “the line.” But you will find it on page 4 of the 1944 form.
Likewise, after 1944, the idea of “itemized deductions” was born, because while taxpayers had to substantiate all deductions taken from gross income to determine AGI, they only had to substantiate those deductions taken from AGI to determine taxable income if they chose to itemize them.
In 1954, these ideas were codified in sections 62 and 63. Section 62 became the definition of “Adjusted Gross Income” and listed those deductions that would be allowed to be taken from gross income to determine AGI. Section 63 became the statute that very simply gave taxpayers the ability to elect to take a standard deduction. In 1954, §63 had only two subsections. And the term “itemized deductions” became part of the titles of both Subchapter B, Part VI (“Itemized Deductions for Individuals and Corporations”) (§§161-175) and Subchapter B, Part VII (“Additional Itemized Deductions for Individuals”) (§§211-217).
Law: Creation of the Great Divide in 1986
The separation of deductions into above-the-line and below-the-line created a discrimination. If a deduction was permitted above the line, you could take it PLUS the standard deduction. You could take both. But to the extent a deduction was only permitted below the line, it had to fight with the standard deduction: you could get one or the other but not both. In 1945 almost 83% of individuals took the standard deduction. IRS Statistics of Income (SOI) for 1945. Over time, as the standard deduction amount shrank in real terms, the number of taxpayers taking the standard deduction shrank. In 2016, for example, 68.6% of returns elected the standard deduction. SOI for 2016 at 20. Then Congress doubled the amount in 2017 and, predictably, the percentage rose, to 87% in 2018. SOI for 2018 at 22.
While that fight between itemized and standard deductions was important it was not huge, especially as the standard deduction amount shrank in real terms. If your itemized deductions exceeded the standard deduction, then at least they got you the same dollar-for-dollar reduction in income as an above-the-line deduction did. While Congress messed around with §63 by changing the idea of a standard deduction to a “zero-bracket amount” in 1978, it did not otherwise differentiate between deductions taken above or below the line.
That all changed with the Tax Reform Act of 1986, P.L. 99-514, 100 Stat. 2085, 2113. As all readers should know, the Tax Reform Act of 1986 was probably the greatest bi-partisan effort to simplify the tax laws, lower tax rates, and expand the tax base. See generally, Tax Reform: Lessons From The Tax Reform Act Of 1986, Hearings Before the Senate Committee on Finance, S. Hrg. 111-1093 (September 23, 2010).
One of the simplification and base-expanding moves was to create the Great Divide.
First, Congress amended §63 to explicitly define “itemized deductions” as being “the deductions allowable under this chapter other than— (1) the deductions allowable in arriving at adjusted gross income, and (2) the deduction for personal exemptions provided by section 151.” 100 Stat. 2101.
Second, Congress created a new section, §67, where it created a new subset of itemized deductions it termed “miscellaneous itemized deductions.” Section 67(b) provided that “the term 'miscellaneous itemized deductions' means the itemized deductions other than—” a long list of the traditional non-business deductions such as those for charitable contributions, interest expenses, medical expenses, etc. 100 Stat. 2114. Thus, the world of below-the-line deductions became divided into those items of deduction listed in §67(b) and those not so listed. The latter group were the “miscellaneous itemized deductions.”
Third, Congress imposed a special limit on the deductibility of this newly classified group of "miscellaneous itemized deductions." Section 67(a) provided that “the miscellaneous itemized deductions for any taxable year shall be allowed only to the extent that the aggregate of such deductions exceeds 2 percent of adjusted gross income.”
In 2017 Congress turned the Great Divide into an yawning chasm by adding §67(g), which provides that “notwithstanding subsection (a), no miscellaneous itemized deduction shall be allowed for any taxable year beginning after December 31, 2017, and before January 1, 2026.” (emphasis supplied).
Today's taxpayer, however, did not have to deal with Evil §67(g), but only with that little, tiny, itty-bitty, teensy-weensy, mumu, 2% floor. To you and me, that 2% floor may be annoying, but it's just a light trim. For today's taxpayer, however, it turned out to be a buzz-cut. Let's look at the facts.
The years at issue were 2104 and 2015. Mr. Gregory appears to own multiple very, very successful car dealerships. Apparently he did a lot of things the right way, claiming to have never had even a losing month in all his years in business, since the late 1980’s, according to this interesting and flattering newspaper interview. According to the interview, his business empire was pulling in over $500 million during the years at issue in today’s case.
Like many rich and successful people, the Gregorys owned a yacht, which they owned and chartered through a company incorporated in the Cayman Islands. They properly elected to have the company treated as a disregarded entity.
Where the Gregorys went wrong was in claiming that owning and chartering the yacht was a business and one that produced losses for each year. That’s an error many taxpayers fall into, as we learned in Lesson From The Tax Court: Yachts Are Pigs, TaxProf Blog (July 1, 2019). Yachts are rarely businesses. They are almost always hobbies. Hobbies of the rich.
Now Congress has some sympathy for taxpayers whose hobbies produce income. In the Tax Reform Act of 1969, P.L. 91-172, 83 Stat. 487, 571, Congress enacted what is now §183, which permits taxpayers to deduct the expenses of their hobby. That’s nice. However, §183 limits the deductions to the income the hobby produces. It does not permit taxpayers to deduct net losses from their hobby and so is often called the “hobby loss” rule. But I like to look on the bright side: I think of it as the “hobby deduction” rule!
On audit, the IRS caught out the Gregorys and recharacterized the yachting activity as a hobby. That meant the yacht chartering gross receipts were not business income but were simply hobby income for the years at issue. The amount of that income for 2014 was $342,000 and for 2015 was $312,000. The opinion does not say what the amount of losses were that the IRS disallowed, but since that is not our lesson, we can ignore that. The IRS’s bottom line, however, was that the Gregorys owed some $267,000 in additional taxes and some $53,000 in §6662(a) penalties.
Thus, according to the opinion §183 authorized hobby deductions of up to $342,000 for 2014 and $312,000 for 2015. However, deductions authorized by §183 are not listed in §62(a) and so are not above-the-line deductions. Worse, these types of deductions are also not listed in §67(b) and so they are not regular itemized deductions. They are instead classified as “miscellaneous itemized deductions” and are subject to a 2% floor. That meant the Gregorys could not take a single dollar of deduction for their hobby activity because, writes Judge Jones, “the Gerogrys’ total miscellaneous itemized deductions for both years at issue were less than 2 percent of their adjusted gross income.” Op. at 4.
Wow. If my calculations are right, that means the Gregorys’ AGI was something like $17 million. Is that what you get? The rich surely are different.
You can see now why the Gregorys hired some lawyers and attempted to convince the Tax Court that they should be able to take their §183 hobby deductions above the line. They could not, however, cross the Great Divide. Let’s see why.
Lesson: Sections 62, 63 and 67 Apply to All Deductions.
Sections 62, 63, and 67 tell you how to calculate taxable income. It's a three step process. As I keep reminding my students, those three section do not themselves authorize any deduction. You must find the relevant authorization in a different statute and follow that statute's rules to determine a deduction's amount. These statutes just tell you how to use the deduction to calculate, ultimately, taxable income.
The Gregorys put forth two deeply confused arguments for why §183 deductions should be allowed above the line. First, they argued the “plain language” of §183 made it an above-the-line deduction. Second, they argued that since §183 had been enacted in 1969, the changes Congress made to §67 in 1986 could not apply to it.
The first argument confuses the allowance of a deduction with how it is used to calculate taxable income. Judge Jones walks us through the standard analysis: deductions are divided into above-the-line and below-the-line. In order to be above the line, a deduction must be listed in §62(a). The deduction permitted by §183 is not listed there. So it goes below the line. Easy.
The Gregorys burbled that §183 itself does not mention anything about a 2% floor! Yup. That's right. It's just a statute authorizing a deduction, not instructing how to use the deduction to calculate AGI or GI. Judge Jones writes: "The language they point to in support of their argument concerns only the maximum permissible amount of the deduction. It does not instruct taxpayers to apply the deduction itself aginst gross income for purposes of calculating AGI."
The second argument is even more bizarre. It assumes that either §183 or §67 must apply, but not both. To suggest such a conflict reflects a deep misunderstanding of tax law, the kind of misunderstanding that my beginning tax students have. Writes Judge Jones: "in fact each provision may be given effect without precluding or otherwise undermining application of the other." Before 1986 hobby expense deductions were still taken below the line. If a taxpayer elected to itemize, the deductions were a dollar-for-dollar reduction in AGI to calculate taxable income. The 1986 legislation did not change where the hobby expenses were taken. It just created the Great Divide, between itemized deductions and miscellaneous itemized deductions subject to a 2% floor. Why are grown-up attorneys presenting this argument to the Tax Court??
Comment: Why No §183 Netting?
While not entirely clear from Judge Jone's opinion, I think what the taxpayers may have been trying to argue is that §183 should be read to permit the netting of hobby expenses with hobby income to determine the amount of hobby income to report. The argument would be a policy argument: that Congress intended to allow taxpayers to treat hobby income the same as business income, just like Congress treats investment and rental income like a business income in §212. That might work for a COGS type of expense—such as I might incur in my hobby of canning fruit from my garden and selling it. But it's an equally empty argument for the hobby expenses analogous to the ordinary and necessary expenses authorized by §162, for two reasons.
First, When Congress wants to permit taxpayers to net, it says so explicitly, such as in the §165(h) hotchpot permitting personal casualty losses to be netted against casualty gains in order to determine net casualty losses. Without explicit netting rules, one much rely on the rules in §62, §63, and §67. Look at the treatment of gambling deductions, for example. Section 165(d) limits those to the amount of gambling income. But that does not by itself permit netting. Taxpayers must use the rules in §62 etc. See Bryan Camp, Taxation of Electronic Gaming, 71 Wash & Lee L. Rev. 661 (2020) (collecting cases, including hobby loss cases). Similarly, there is no netting in §212. Sure you can deduct §212(2) expenses above the line, that is only because §62(a)(4) authorizes it.
Second, the policy argument misses the correct analogy. The point of §183 is to permit a deduction for personal expenses which would otherwise be denied by §262. It does so by pretending the personal expenses are business expenses, not by treating the hobby income as analogous to business income.
I am personally sympathetic to the policy argument. Perhaps netting is the statute Congress should have written, but it has long been interpreted as not being the statute Congress actually wrote. It does not take much research to see that. Which takes me to. ...
Comment: Why No §6673 Penalties?
On the one hand, I can understand why Mr. Gregory wanted to try and get his yacht chartering expenses moved to above the line. Because of the Great Divide it was an all or nothing issue involving over $300,000 of deductions each year.
On the other hand, if I am right that this dude had income north of $17 million each year, then $300,000 is pretty small potatoes. More importantly, even if significant, that does not justify hiring attorneys to waste both agency and Court resources with such patently groundless arguments, arguments that reflects a Tax 101 misunderstanding of the law. That is what that §6673 penalties are designed to address. They apply not only to frivolous arguments from tax protestors, but also to arguments that are simply groundless. As Judge Gufstason reminded us a few weeks ago, “the purpose of section 6673 is to compel taxpayers to think and to conform their conduct to settled principles before they file returns and litigate.” Kaeble v. Commissioner, T.C. Memo 2021-109 (quoting Takaba v. Commissioner, 119 T.C. 285, 295 (2002)). Here, of course, a $25,000 penalty means nothing to man of Mr. Gregory's wealth. It's probably not even pocket change. I still think Judge Jones could have considered it. But maybe the rich really are different...they can present groundless arguments with no fear of incurring a penalty that matters.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each week to TaxProf Blog for another Lesson From The Tax Court.