When it comes to tax time, we like to see losses. Losses may reduce or completely wipe out taxable income. The prospect of paying no taxes sometimes puts on display a taxpayer’s over–creativity to generate losses. Tuesday’s U.S. Tax Court case of Ronald J. Zenzen illustrates why a taxpayer can’t just claim one ran a business in order to create business losses that would otherwise be nondeductible personal expenditures.
Zenzen enjoys drag racing. He’s been involved with the sport in some capacity since 1970. In 1998 he bought a car, and together with his two sons, a racing team was born. Over the years, Zenzen purchased and improved cars to participate in various drag racing activities, and incurred various expenses along the way.
To each of his 2005, 2006, and 2007 tax returns, Zenzen attached a Schedule C claiming income and expenses relating to drag racing business activity. Among the three years, the Schedule C expenses totaled at least 29 times Schedule C income and at most 171 times Schedule C income. Of course, with no more than $950 of drag race income from each year, such disparities are not surprising. Zenzen claimed for each year a net business loss of $24,194, $33,752, and $59,714, respectively.
In order to offset other ordinary income with a Schedule C business loss on a tax return, a taxpayer must actually run a business in the first place. Therein lied Zenzen’s problem. The auditor disallowed each of the Schedule C losses on the basis that Zenzen was not engaged in the drag racing activity with the intent to make a profit. If not engaged in for profit, Zenzen could deduct his expenses only up to the extent of gross income from the activity. Big difference in this case.
The Treasury regulations provide a list of factors to consider in determining whether an activity is engaged in for profit. The burden of proof on this issue is on the taxpayer. In this case, the court considered the following factors:
- Expertise of the taxpayer or his advisors;
- Time and effort expended in carrying on the activity;
- Expectation that assets may appreciate in value;
- Success of taxpayer in other activities;
- Taxpayer’s history of income or losses;
- Amount of occasional profits, if any;
- Financial status of the taxpayer; and
- Elements of personal pleasure
Zenzen came up short for several reasons. He didn’t maintain books or records or have a business plan. Although Zenzen had “extensive expertise” with drag racing, he failed to show he had “requisite expertise regarding the business aspects of drag racing.”
It was clear Zenzen put a lot of time into drag racing, but it was more akin to a hobby. For each year in issue, Zenzen and his wife earned over $115,000 combined in wages from sources unrelated to drag racing. The court emphasized that the presence of such income, particularly if losses from the activity in question generate significant tax benefits, may indicate that the activity is not engaged in for profit.
For taxpayers considering filing a Schedule C, this case is helpful in evaluating whether the activity in question is engaged in for profit. Just because a Schedule C produces favorable tax breaks doesn’t necessarily mean the decision to attach one to a tax return will be upheld in court. In this case, the IRS took home the trophy.