Many taxpayers have a hobby or sideline that they pursue in the hope of earning additional income. In calculating their profits from this “business,” taxpayers are allowed by IRC section 183 to deduct expenses as long as the expenses are not categorized as “personal.” In one recent case, the Tax Court analyzed the taxpayer’s returns for several years and determined that she was in the business of being an artist and could deduct related expenses, even though she made a profit from her art in only one of 42 years. The authors disagree with the Tax Court’s reasoning and explain why, as well as provide advice for tax professionals facing similar situations.
In a recent U.S. Tax Court case, Crile v. Commissioner, the court concluded that a taxpayer—despite suffering losses for 41 of 42 tax years—was primarily motivated by a desire to earn a profit (TC Memo 2014-202). The court’s conclusion about the taxpayer’s motivation was critical, because taxpayers generally cannot deduct losses produced by activities that are not profit motivated. An activity is profit motivated only if the taxpayer’s primary intent is to earn a profit. Determining the taxpayer’s intent requires a fact-intensive, multifactor analysis, but common sense indicates that if someone persists in pursuing an activity in the face of significant and recurring losses over many years, she might not be primarily motivated by profit. The Crile decision, however, challenges this conclusion. The authors believe the decision was strongly influenced by the nature of the taxpayer’s purported business activity: art.
As a general rule, taxpayers may only deduct expenses associated with profit-motivated activities under IRC section 183(a). Thus, taxpayers generally may not deduct expenses associated with activities that are not profit motivated, that is, “personal” expenses [IRC section 262(a)]. There are, of course, many familiar exceptions to this general rule (e.g., qualified residence interest, property taxes on a personal residence, medical expenses), but they are mostly itemized deductions subject to substantial limitations.
Because of this disallowance or limitation of personal deductions, taxpayers sometimes expend a great deal of energy trying to characterize their personal activities as profit-motivated. This most often manifests itself when taxpayers engage in activities that bring them pleasure or enjoyment. These hobbies usually produce significant expense but little income. Notwithstanding these net losses, taxpayers often take the position that they intend to earn a profit from the activity, and that it is therefore a business. If successful, the taxpayer may deduct otherwise nondeductible personal expenses. In addition, the taxpayer may deduct the excess hobby expenses against other income (typically salary or income from another business or professional activity). The IRS takes a dim view of these efforts and routinely challenges taxpayers’ characterizations of loss-producing hobby activities as businesses. This is what happened in Crile.
The Crile Case
Susan Crile, the taxpayer, served as a tenured professor of studio art at Hunter College in New York City and produced artwork for more than 40 years. Beginning in 1971 and continuing until at least 2012, Crile’s art activity produced a profit in only one year, 1995; the specific tax years at issue in the case were 2004, 2005, 2007, 2008, and 2009. Upon audit, the IRS challenged Crile’s position that her art was an activity entered into for profit, arguing that section 183(b) limited her deductions to the amount of gross income (if any) the activity produced. Exhibit 1 summarizes Crile’s reported income and expenses related to her art activity for the tax years in question.
Crile v. Commissioner, Total Income and Expenses Reported by Tax Year
The court quickly dealt with the question of whether Crile’s art activity and her teaching activity should be treated as a single activity, reasoning that Crile’s work as an artist began a decade before she began teaching as a professor, and that the two professions represent “two distinct activities” requiring different skill sets. The court then turned its attention to the primary issue and applied the relevant section 183 regulations to determine whether Crile had entered into her activity with the “predominant, primary, or principal objective of earning a profit,” acknowledging that Crile bore the burden of proof with respect to this issue. The regulations establish a non-exclusive nine-factor test to determine whether a taxpayer has engaged in an activity for profit [Treasury Regulations section 1.183-2(b)]. The specific factors and the court’s decision in Crile with respect to each of those factors are summarized in Exhibit 2. Based on its application of these factors to Crile’s facts, the court determined that Crile had “an actual and honest objective of making a profit” and agreed that her art activity was a business (Crile, at 23).
Crile v. Commissioner, Tax Court’s Application of Regulatory Factors
It is important to bear in mind the legal standard applicable to the case. IRC section 183(a) states, in relevant part, that “if [an] activity is not engaged in for profit, no deduction attributable to such activity shall be allowed.” An activity is engaged in for profit for this purpose if the taxpayer’s “predominant, primary or principal objective” in engaging in the activity is to realize an economic profit independent of tax savings [Wolf v. Commissioner, 4 F.3d 709, 713 (9th Cir. 1993), affirming T.C. Memo. 1991-212]. Therefore, Crile needed to demonstrate not that profit was an objective, or even a significant objective, but that it was her most important objective. Although a taxpayer’s intent is subjective, the regulations provide nonexclusive, objective factors intended to assist the court in its determination of that intent. The taxpayer’s intent is to be determined by all of the facts and circumstances, and, more importantly, in applying the factors “greater weight is accorded to objective facts than to the taxpayer’s subjective statement of intent” [Treasury Regulations section 1.183-2(a)].
Given this legal standard, Crile’s burden of proof, and the facts, the authors believe that the Tax Court got this one wrong. No person who engages in an activity for four decades and continually loses significant amounts of money has a primary objective of engaging in that activity for profit. The following analysis addresses the factors, as the court did, in their regulatory order.
Manner in Which Activity Is Conducted
According to the regulation, “the fact that the taxpayer carries on the activity in a businesslike manner and maintains complete and accurate books and records may indicate that the activity is engaged in for profit” [Treasury Regulations section 1.183-2(b)(1)]. After reviewing the facts, the court concluded that this factor favored Crile.
On a superficial level, this factor might seem strictly formal: If a taxpayer satisfies certain formal requirements (e.g., has business cards, maintains a separate bank account and credit card, maintains books and records, makes an effort to market and advertise), then she arguably has satisfied this factor. The court in Crile appeared impressed that “petitioner sent exhibition announcements to her mailing list of 3,000 collectors” (Crile, at 23); however, her total claimed advertising expenses amounted to only $1,182 for the five tax years before the court, and were $0 in three of those five years. If all a taxpayer must do is merely show expenses in a particular category or maintain certain types of records, then this factor becomes so easy to satisfy that it is practically meaningless.
The regulation and former court decisions indicate, however, that this factor also has a substantive aspect. For example, the regulation also states: “A change of operating methods, adoption of new techniques or abandonment of unprofitable methods in a manner consistent with an intent to improve profitability may also indicate a profit motive” [Treasury Regulations section 1.183-2(b)(1)]. This implies that, to fully satisfy the factor, books and records must be used specifically to provide the taxpayer with information needed to reduce losses or improve profitability. In this regard, the Tax Court itself recognized in Golanty v. Commissioner that “the purpose of maintaining books and records is more than to memorialize for tax purposes the existence of the subject transactions; it is to facilitate a means of periodically determining profitability and analyzing expenses such that proper cost saving measures might be implemented in a timely and efficient manner” [72 T.C. 411, 430 (1979), affirmed without published opinion 647 F.2d 170 (9th Cir. 1981)].
In Crile, the court concluded that she “conducted her art activity in a businesslike manner. All of the elements we have discussed, except her failure to use expense records to reduce losses, indicate that she had the requisite profit objective” (Crile, at 34, emphasis added). In the authors’ opinion, the court missed the point. Crile may have satisfied the formal requirement of maintaining records, but she didn’t seem to use them for anything. Those records told her that her activity was losing money, lots of it, nearly every year. Getting customers to buy her product was not directly within her control, and the facts reveal that what little she did do to improve sales was unsuccessful. She certainly had control over her expenses, however, and the court itself noted that she made no attempt to control costs (Crile, at 31). She appears to have been completely unconcerned with the existence and magnitude of her losses, which indicates that she was not primarily motivated by a desire for profit.
Expertise of Taxpayer
The second factor addresses the taxpayer’s expertise or, if applicable, that of the taxpayer’s advisors. The court concluded that “there is no dispute that petitioner ranks at the top of the scale in terms of expertise as an artist” and that this factor strongly favored Crile (Crile, at 35). Not being artists or art critics, the authors readily concede that Crile had expertise in being an artist, but she seems to lack expertise in the business of selling art.
The court several times remarked approvingly that Crile was a “successful” artist and noted that the IRS agreed with this conclusion (Crile, at 3). But it is not clear to the authors why the IRS agreed that Crile was a successful artist or why her “success” was more important than profitability. The IRC and the regulations, as the authors understand them, do not require that the taxpayer intend to be successful; they require that the taxpayer intend to be profitable.
The court clearly confounded success and profitability. The court stated, “It is very difficult to predict when success will occur in the art world” (Crile, at 17). Here the court presumably meant financial success—that is, profitability—because it already concluded that Crile had achieved artistic success. But during the five-year period before the court, Crile incurred $287,000 of expenses to produce only $16,000 of income. In any event, the court’s analysis is subject to essentially the same criticism as with the first factor. First, the regulation clearly focuses on the taxpayer’s expertise in the business of selling the taxpayer’s product or service, not necessarily the underlying personal skill in creating or producing it. The regulatory inquiry is whether taxpayers have obtained expertise (themselves, or vicariously through their advisors) in the “accepted business, economic, and scientific practices” relevant to the activity. Thus, the regulations seem to distinguish, for example, between a singer with great expertise in singing and one with expertise in the music business.
More importantly, the regulations make clear that the taxpayer’s expertise is not merely a formal consideration. The important point is not that the taxpayer (or her advisors) possesses expertise, but that she applies that expertise to improve profitability. The regulation says, “Where a taxpayer has such preparation or procures such expert advice, but does not carry on the activity in accordance with such practices, a lack of intent to derive profit may be indicated unless it appears that the taxpayer is attempting to develop new or superior techniques which may result in profits from the activity” [Treasury Regulations section 1.183-2(b)(2)].
With respect to Crile’s advisors and their expertise, the court acknowledged that she “did not retain professional business consultants. Rather, her principal ‘advisors’ were the galleries that represented her” (Crile, at 35). This strategy had been manifestly unsuccessful for more than 30 years. Her failure to materially change strategies (other than to change which gallery displayed her art) to improve profitability indicates that she was not primarily motivated by an intent to earn a profit. Moreover, if Crile was such a successful artist, she didn’t need artistic advice, but rather business advice, which she failed to seek. Notwithstanding her long history of losses, the court concluded that Crile “understood the general factors that affect the pricing of art—a history of sales, gallery representation, solo exhibits, positive critical reviews, and prestigious public accolades—and she worked diligently to achieve these credentials. Petitioner is without doubt an expert artist who understands the economics of her business” (Crile, at 36). Given her lack of economic success, however, this seems doubtful.
Taxpayer’s Time and Effort
In applying this third factor, the court stated that the “fact that a taxpayer devotes considerable time and effort to an activity may indicate a profit objective” (Crile, at 36, citing Giles v. Commissioner, T.C. Memo 2006-15). The court concluded that this factor strongly favored Crile. It appears to the authors, however, that much of Crile’s time and effort were devoted to activities that were either enjoyable social activities (networking with “important people in the New York art world”) or activities that she would have engaged in even were she not in the art “business” because of her position as an art teacher.
Expectation of Appreciation in Value
The fourth factor addresses the taxpayer’s expectation that assets used in the activity will appreciate in value; such an expectation, according to the regulations, may indicate a profit motive [Treasury Regulations section 1.183-2(b)(4)]. According to the court, the “relevant question is whether petitioner could reasonably entertain an expectation that the value of her inventory would eventually appreciate significantly” (Crile, at 39). The court concluded that Crile had such an expectation, but such an expectation, to be reasonable, must be based on something.
The IRS pointed out that Crile’s only asset, her art, had not materially increased in value during the nearly four decades Crile had been producing it, and that it could not reasonably be expected to ever appreciate to the point that it would offset her four decades of losses. This last point was important because the Tax Court itself has held that the taxpayer’s objective “must be to realize a profit on the entire operation—future net earnings and also enough earnings to recoup losses that have been incurred in intervening years [Bessenyey v. Commissioner, 45 T.C. 261, 274 (1965), affirmed 379 F.2d 252 (2d Cir. 1967), emphasis added]. But the court was unimpressed, and concluded that this factor strongly favored Crile.
The court noted that “during 2004–2009 petitioner had an inventory of at least 1,500 pieces of art available for sale.” Even if Crile produced one piece of art every working day of the year, 1,500 pieces of art is at least six years’ worth of production. According to the Tax Court, having a huge inventory that cannot be sold is a good thing in the art business. “All in all, we find that [Crile] entertained a reasonable expectation that her artwork, over the course of her career, would appreciate significantly in value, and that this expectation explains her ‘willingness to continue to sustain operating losses’” (Crile, at 42). The facts presented in the decision itself contradict this conclusion. There is no factual evidence that Crile could ever sell the inventory for any price, much less that it had appreciated substantially in value, or that it ever would.
Were Crile’s losses incurred only in the startup phase, they would not per se indicate a lack of profit motive. But after 40 years, her activity clearly was no longer in the startup phase.
History of Income or Losses
According to the regulation, the fact that a taxpayer incurs a series of losses beyond an activity’s startup years may imply the absence of a profit objective. This factor should have been an important factor in Crile, but the court gave it little weight. Crile’s history of unrelenting losses, coupled with her almost complete lack of effort to control costs and minimal and ineffectual efforts to increase revenue, clearly indicates that she was not primarily motivated by a desire to make a profit from this activity. During the five years in question, Crile incurred $287,000 of expenses to produce only $16,000 of total income.
As the court recognized, Crile had only one profitable year out of 42. Were Crile’s losses incurred only in the startup phase, they would not per se indicate a lack of profit motive. But after 40 years, her activity clearly was no longer in the startup phase. Moreover, as the IRS pointed out, it is not enough that Crile intended that the activity would merely become profitable, but that the anticipated future profits would be sufficient to make up for nearly four decades of losses. It is hard to imagine how, given this set of facts, Crile could reasonably justify any such expectation.
The court attempted to explain away Crile’s history of losses, saying: “It is well recognized that profits may not be immediately forthcoming in the creative art field. Examples are legion of the increase in value of a painter’s works or a sculptor’s works after he or she receives public acclaim” (Crile, at 44) That may be so, but according to the court, Crile received public acclaim many years ago.
The court also noted that there is “a limited commercial market for petitioner’s works” (Crile, at 36). It is not readily apparent how this helps Crile’s position. Whether a taxpayer makes duck calls, auto parts, or computer chips, if there is “a limited commercial market” for the product and the taxpayer cannot make a profit selling it, the taxpayer eventually gets out of the business. Here Crile continued to produce her product even though she could not sell it profitably. The fact that she never pulled the plug indicates that she was not primarily motivated by a desire to make a profit.
Amount of Occasional Profits
The regulation states that “occasional profits from an otherwise money-losing venture may support the existence of a profit motive” [Treasury Regulations section 1.183-2(b)(7)]. Here again, the court was compelled to recognize that this factor favored the government: “Given that petitioner has had only two years of profits, we find that this factor weighs in respondent’s favor, but not terribly heavily.” The court again did what it could to downplay the significance of this factor. For example, the court noted approvingly that “[Crile] has earned income of approximately $667,902 from sales of 356 works of art between 1971 and 2013.” But this factor addresses occasional profits, not occasional income. Profit exists when the taxpayer’s income exceeds expenses; focusing on only income is inappropriate.
In a similar vein, the court also analogized the art business to wildcat oil drilling, saying that “they are both speculative ventures in which the taxpayer can hope to realize a very large return from a relatively small investment.” It certainly appears that over the four decades of the activity’s existence, Crile has made a significant investment. Moreover, even if the court’s analogy—that the art “business” is, like wildcat oil drilling, speculative—is applicable, at what point does that activity go from speculative to hopeless? As far as the authors can determine, Crile is about 73 years old. Will her “business” ever become profitable? If so, when? And will those profits be enough to make up for more than four decades of significant losses? Must Crile’s fellow taxpayers subsidize her hobby indefinitely? These are important questions that the court’s decision leaves unanswered.
In applying this factor, the court made the surprisingly nonchalant and sanguine observation that Crile deducted many expenses that were clearly personal:
The trial established that a significant number of the deductions she claimed were not, within the meaning of section 162(a), “ordinary and necessary expenses” of conducting her art business but were “personal, living, or family expenses” nondeductible under section 262(a). The latter expenses appear to have included telephone and cable television bills, newspaper and magazine subscriptions, gratuities to doormen in her apartment building, taxicabs to the opera, museums, and social events, restaurant meals with friends and acquaintances, and international travel to gain inspiration from paintings in European museums (Crile, at 22).
Rather than simply denying these unwarranted deductions and proceeding with its analysis, the court used them for a surprising purpose—to help Crile’s case. The court recognized that Crile had experienced losses for more than 40 years, but was also “convinced that the magnitude of these reported losses is explained in large part by her practice of claiming on her Schedule C deductions for many expenses that were actually personal in nature. But for this, she would have reported significantly smaller losses for all years and quite possibly additional profits for some” (Crile, at 45).
Even if the court eliminated more than 90% of Crile’s total claimed deductions, she still would not have had a profit in any of those years. There seems to be no reason to believe, given Crile’s practice of deducting personal expenses, that the situation was any different in Crile’s previous tax years. The court essentially said, “Don’t worry, we’re going to eliminate most of the taxpayer’s unwarranted deductions.” But it did not even mildly reprimand Crile (or, perhaps more surprisingly, her return preparer) for deducting all of these personal expenses. Furthermore, it allowed Crile the double benefit of deducting the clearly personal expenses for many years and disavowing those same expenses for purposes of determining whether she was engaged in the activity for profit. The court’s approach seems to have the perverse effect of providing taxpayers with an incentive to load up on questionable expenses, knowing that they will be ignored for section 183 purposes. The IRS objected to being whipsawed in this manner, but the court brushed the objection aside.
Taxpayer’s Financial Status
The regulation provides that “substantial income from sources other than the activity (particularly if the losses from the activity generate substantial tax benefits) may indicate that the activity is not engaged in for profit, especially if there are personal or recreational elements involved” [Treasury Regulations section 1.183-2(b)(8)]. This factor again seems to cut against Crile, who had a substantial teaching salary and other income. But the court designated the factor only as “neutral,” saying: “We find that petitioner’s art business was her primary activity; she did not become an artist in order to shield her other income from taxes” (Crile, at 50). That may be true, but the court completely ignored the real significance of Crile’s other significant income in the years at issue: it allowed her to pursue her hobby. But for her professor’s salary (or her other sources of significant income), she would have been financially unable to continue to incur significant art activity losses year after year. Crile’s art activity losses shielded a substantial portion of her faculty salary and other income from federal income tax, the very result that section 183 is intended to prevent.
Elements of Personal Pleasure
With respect to this last factor, the regulations provide that the “presence of personal motives in carrying on of an activity may indicate that the activity is not engaged in for profit, especially where there are recreational or personal elements involved” [Treasury Regulations section 1.183-2(b)(9)]. The court recognized that “it is obvious that [Crile] derives pleasure from making art,” but nonetheless concluded that this factor was either neutral or even slightly favored Crile (Crile, at 51–52).
This case, like all IRC section 183 cases, required the Tax Court to determine Crile’s subjective intent. While the authors recognize that determining intent can be difficult, they disagree with the court’s determination. The factors could—and in the authors’ opinion should—have been applied much differently, given the facts and Crile’s burden of proof. At best the facts demonstrated that Crile was motivated by a desire to sell her artwork, but she was clearly indifferent to whether she did so profitably. Nonetheless, the court, with its thumb on the scale, applied the factors in a manner most favorable to Crile.
The court did not conclude that any of the factors—not even Crile’s long history of losses—“strongly favored” the government. In contrast, the court characterized no fewer than four of the factors as “strongly” favoring Crile, and even gave Crile the nod on several otherwise “neutral” factors. Most importantly, by ignoring or explaining away Crile’s long and almost unrelenting history of losses, the court effectively concluded that artists are in a perpetual “startup” phase.
There is still more to be learned from the Crile decision. First, Crile was obviously well advised and well prepared for trial, which the authors’ research indicates is unusual in this type of case. Crile hired a large and reputable New York law firm, and this litigation might well have cost her a small fortune. In comparison, the typical IRC section 183 case involves a pro se taxpayer, unprepared for trial, with little or no evidence marshaled to support their position. Here, in contrast, Crile hired experienced, talented, and undoubtedly expensive legal talent. The authors cannot doubt that Crile’s excellent representation and preparation contributed significantly to the outcome in her case.
Second, the authors’ research indicates that taxpayers pursuing activities other than art are not as likely to benefit from the Tax Court’s credulity and largesse as Crile. (See, e.g., Strode v. Commissioner, T.C. Memo 2015-117, and Price v. Commissioner, T.C. Memo 2014-253.) The Tax Court appears to have a soft spot for artists, and the court’s decision may be a case of a conclusion in search of a rationale. In particular, the court justified its decision, at least implicitly, with its “give with one hand, take with the other” approach of agreeing that Crile’s activity was a business while simultaneously denying a substantial portion of her claimed deductions. Certainly the court must take into account the particular nature of the taxpayer’s activity in evaluating and applying the factors. But is art really so extraordinary that it deserves its own watered-down standard? The court’s solicitude for “starving artists” seems inapplicable, both in general and in Crile itself.
Artists generally produce a product for sale to customers. The court seems to have concluded that many artists, including Crile, are unique in the sense that they produce their art without much attention to economic implications, devoting their efforts to—and being primarily motivated by—a desire to express their artistic talent rather than a desire to earn a profit. But that lack of profit motive puts them squarely in IRC section 183(a)’s path, which denies the losses produced by their activities. If artists are to have a special, more lenient section 183 standard than other taxpayers, such standard should come from Congress, not the Tax Court. And with respect to Crile herself, she was anything but a starving artist. She had significant income from sources other than her art activity, income that was shielded from federal income tax by her hobby losses, a result section 183 is intended to prevent.
If artists are to have a special, more lenient section 183 standard than other taxpayers, such standard should come from Congress, not the Tax Court.
Third, and perhaps most importantly, the objective economic facts clearly indicated that Crile was not primarily motivated by a desire to make a profit. Crile lost money, often a lot of money, in 41 out of 42 years. The “soft” noneconomic facts, coupled with the court’s surprisingly optimistic expectation that her artwork would appreciate in value, won the case for Crile. While this produced a surprising result in this particular case, it is also good news for other taxpayers. The Crile decision demonstrates that the factors that are most easy to satisfy do matter—and can matter a great deal. If a taxpayer conducts herself professionally, keeps records, has a business plan (even an unwritten one), advertises (even minimally), can demonstrate expertise in her hobby activity, enjoys a good reputation in her field, and can demonstrate that her activity involves hard work and has mundane aspects, then the taxpayer stands a good chance of successfully defending the position that her hobby is a “business,” even if she rarely, if ever, earns a profit.