Saving Taxes by Winning the IRS Economic Substance and Profit Motive Tests

Creating wealth requires tax planning that looks down the road at new trends.  After the KPMG tax shelters, Congress passed a new law to codify the existing court case law.  For any tax plan to succeed, the plan must have economic substance and a profit motive.

But there is a problem.  These concepts are subjective based upon appearance.   This blog will teach you the do’s and the don’ts of these “emotionally” based laws.  

If challenged, the judge’s emotional belief (and not a black and white tax law) will determine if you win or lose. 

Establishing a profit motive is the key in avoiding the new economic substance and the large (40%) tax penalty.   The old hobby loss rules and court cases provide us with the knowledge needed for successful tax planning.

I used for this blog the IRS regulations that have nine factors.   I also have used a comparison of court cases in which the taxpayers did demonstrated the existence of a profit motive and economic substance  with those court cases in which the taxpayers did not.     I  list those court cases at the end of this blog.

If you would like to brainstorm your tax planning, then please call me, Brian Dooley CPA, at 949-939-3414 for a free one hour consultation.

Manner in Which the Activity Is Conducted

The “ Dos”-

  1. This may seem silly, but prepare a business plan, including a break-even analysis determining the amount of income necessary for the activity to be profitable in light of the anticipated costs of the activity and financial projections determining how long it should take for the activity to become profitable.    Besides being prudent, it proves to the IRS that you were thinking about profit and not merely tax savings.
  2. Next is accounting.   Keep detailed and accurate books and records.   Keep separate checking accounts for each activity.
  3. Acting like a business is a must. Here are some thoughts. Advertise and promote the activity in a business-like manner.    Make major decisions relating to the activity in a businesslike manner, based on the records.   If the activity is initially unsuccessful, make changes to the operation designed to contain costs and avoid further losses.    Keep expenses as low as possible.
  4. If applicable, be prepared to demonstrate the circumstances beyond your control that prevented compliance with the business plan.
  5. Consult with experts before entering the activity and as needed to conduct the activity successfully.  Engage in research and study to increase expertise regarding the activity.  Conduct the activity in accordance with such study or advice.
  6. Your expectation that the assets will appreciate in value show a profit motive.   In researching the amount of income needed to realize profit from an activity, take into account the appreciation of assets used in the activity as well as profit from current operations.    Be prepared to show that appreciation (actual or reasonably expected) is substantial in relation to losses.
  7. Be aware of the length of the start-up period customarily required to make similar activities profitable.    Be prepared to demonstrate that the amount of losses was customary or usual for the activity.  Also, keep track of business circumstances, personal setbacks beyond the your control, and unforeseen occurrences that may result in losses for a longer than usual period.
  8. Be willing to sustain continued losses because of the existence of other financial resources, in situations where the prudent business decision would be to cut the losses by terminating the activity.   Be prepared to demonstrate any significant trend in which net losses decrease over time.  Report any profits from the activity, no matter how small they are or how seldom they occur.

The Don’ts –

  1. Commingle proceeds of the activity with personal funds.
  2. Having losses grow without making efforts to change operations or consult experts on how to cut costs and increase profits.   Incur continuing losses of a magnitude out of proportion to the expected gains from the activity, including the gains necessary to recoup losses in prior years.
  3. Limit consultation with experts to information on the tax deductions  of losses. The IRS will look at all of your emails and texts on to your tax advisers.  This consultation indicates your primary goal is tax savings and not a real business or investment.
  4. Limit consultation with experts to information on how to conduct the activity that would be useful to an amateur engaging in the activity. The key is how to conduct the activity for profit.
  5. Disregard the results of a study or expert advice in making major decisions relating to the activity.
    Court Cases for Advance Study.

    Keanini v. Commissioner, 94 T.C. 41 (1990);
    Schwartz v. Commissioner, T.C. Memo. 2003-86;
    Rinehart v. Commissioner,; ME 2002-9}} T.C. Memo. 2002-9;
    Routon v. Commissioner, T.C. Memo. 2002-7;
    Tamms v. Commissioner, T.C. Memo. 2001-201.
    Dreicer v. Commissioner, 78 T.C. 642(1982), aff’d without opinion, 702 F.2d 1205 (D.C. Cir. 1983); Hastings v. Commissioner, T.C. Memo. 2002-310;
    Peacock v. Commissioner, T.C. Memo. 2002-122;
    Bush v. Commissioner, T.C. Memo. 2002-33, aff’d, No. 02-1949 (4th Cir. 2002);
    Dirkse v. Commissioner, T.C. Memo. 2000-356.