Lee and William Storey v. CIR, T.C. Memo. 2012-115 (4/19/2012)
This new Tax Court decision allows a lawyer to avoid the hobby loss rule and currently deduct the costs of making a documentary movie that might be said to be “for fun,” and interprets for the first time Section 181 (enacted in 2004), which permits deduction rather than capitalization of domestic movie production costs.
Lee Storey is a successful attorney whose husband once was a member of an Up With People chorus, a religious singing group movement started in the 1960s. Lee became interested in making a documentary movie about the movement, studied filmmaking and acquired archival footage to be used in the movie. She incurred substantial expense in producing a feature length film, which has been shown at several film festivals but through the years at issue had not produced significant gross receipts. She deducted the production costs as incurred on her joint returns.
The IRS disallowed the deductions on the basis of Section 183, the hobby loss rule. Section 183 disallows deductions incurred in an activity for which deductions might otherwise be allowed, if the activity is not engaged in for profit. The relationship of Section 183 to the other deductions allowance rules, principally Sections 162 and 212, frequently is misunderstood. Neither Section 162 (trade or business expenses) nor Section 212 (activity engaged in to produce gross income) requires a profit to be earned or sought. That is why Section 183 operates independently to deny the Section 162 or 212 deductions if the activity is not engaged in for profit. But then Section 183 provides a pro taxpayer rule: it allows a deduction for expenses up to the amount of the gross income from the hobby loss activity.
In the case of the film, the limited deduction allowance would have been of no use because the film produced effectively no gross receipts. Therefore Lee wanted to deduct the film costs against her joint return income, including her law practice earnings.
The court ruled for Lee on the hobby loss issue. She had done everything right: kept accurate books of her expenditures, gone about the activity in a business-like and professional way, and attempted to make the film a commercial enterprise. The fact that she had enjoyed the process did not make the activity a hobby. It was important that the years at issue, the fourth, fifth and sixth years (2006, 2007 and 2008) of the process of making the film, ended at about the time the film was finally completed, so that the absence of film revenues did not clearly mean that there would be no revenues.
In this regard, Lee’s film activity contrasts with those of other taxpayers who have not kept good records of their activities, not acted as if they even hoped to make a profit sometime and enjoyed apparently vacation-like activities in the process. This scenario frequently is seen in direct sales businesses.
The 2004 tax act added Section 181 to encourage domestic film production. Normally film production costs must be capitalized and written off proportionally when the film produces gross receipts. This section allows earlier deduction if an election is made by the due date for filing the taxpayer’s return for the year in which production costs are first incurred.
The taxpayer filed the election with the 2006 return. The IRS asserted a series of challenges: the election was too late, it should have been by amendment to an earlier year’s return and it did not contain sufficient information. The court rejected all of the challenges. It found that none of the omissions prejudiced the IRS.
Shortly before trial, the IRS raised substantiation as a new issue. Rather than offering proof at trial, it attached a 314-page appendix to its trial brief purporting to prove the lack of substantiation. The court rejected the brief as too long, the proof as improper and ruled for the the taxpayer.
Individual taxpayers face many challenges in reporting a net deduction against their compensation income from losses in other activities; in addition to the hobby loss rules, there are Sections 465 and 469. However, if the activity involves the taxpayer’s direct personal effort, as in the case of filmmaking (or horse raising, etc.), a chance exists for a net deduction. And even if not, then at least the taxpayer can deduct the costs of the activity up to the gross receipts, even if the activity is not a trade or business.