Upholding an Administrative Law Judge decision, the New York State Tax Appeals Tribunal rejected the State Tax Department’s claim that an S corporation’s activities were not engaged in for profit and therefore found that its individual owners could deduct losses from the S corporation on their State resident income tax returns. Matter of Steve and Linda Horn, DTA No. 825333 (N.Y.S. Tax App. Trib., Apr. 20, 2017).
Facts. Petitioners Steve and Linda Horn are a married couple residing in New York. In the 1970s, they started an S corporation (the “Company”), which eventually conducted three different businesses: the television commercial production business, the real estate business, and the antiques business. The case at hand focuses on the years 2004 through 2009 (the “Audit Period”).
Television commercial production business. The Company initially engaged in a television commercial production business carried out by Mr. and Mrs. Horn, along with a cadre of full-time employees and freelancers, some of whom were family members. At the time the business began, Mr. Horn was experiencing financial difficulties and had significant debt arising from a former business. The Company thus was financed by Mrs. Horn and initially operated out of the Horns’ apartment.
Over the decades, the commercial production business became both profitable and professionally recognized, producing commercials for large companies including AT&T, McDonalds, Coke, and Pepsi, along with the iconic “I Love New York” commercials. Mr. Horn, who directed the commercials, earned numerous accolades, and a reel of the business’ commercials has been inducted into the collections of the Museum of Modern Art. However, by 2004 to 2005, market forces, such as the shift from film to digital production, led the Company to begin the process of winding down its commercial production business.
Real estate investment business. In the early 1980s, the Company began engaging in a real estate investment business, focusing on New York City and the surrounding area. The New York area properties sold by the Company were consistently sold at a profit.
In 2004, the Company expanded to the Palm Beach, Florida market, purchasing three properties that required renovations. Many of the needed renovations were delayed by two successive hurricanes that struck the Palm Beach area, and one of the properties was subsequently transferred to a related entity in satisfaction of a loan to the Company by the Horns to purchase the property. Subsequent to the Audit Period, the Company sold one of the properties at a profit.
Antiques business. The antiques business was the brainchild of Mrs. Horn, who admittedly enjoyed the business and found it “fascinating.” In carrying out the antiques business, the Company sought to establish a brand under Mrs. Horn’s name. Numerous employees, including some family members, helped the Company conduct its antiques business, but Mrs. Horn made all inventory purchase decisions. While Mrs. Horn always expected the inventory items to appreciate in value, the initial concept of the business was that it would not be particularly profitable and would be secondary to the commercial production and real estate businesses.
However, once the Company’s commercial production business began the wind-down process in 2004 and 2005, the Company decided to attempt to grow its antique business into a mass market business. As part of the scaling up process, the Company started selling re-creations or reproductions of antiques so that it could offer products at more affordable prices. Additionally, it leased and renovated a new storefront for the antiques business and also renovated properties owned by another related entity leased to the Company and used by it to receive and store inventory.
In carrying out the antiques business, the Company pioneered a number of practices, including tracking the contact information and sales history of every customer who came into the Company’s antiques store, as well as maintaining an information database to store information about the inventory. Certain competitors of the antiques business copied some of these practices.
Audit. During the Audit Period, the Company incurred losses, which for income tax purposes flowed through the S Corporation to the Horns. Some of these losses were claimed on the Horns’ New York State personal income tax returns corresponding to the years in which the losses were incurred, while other losses were claimed as net operating loss carryforwards. On audit, the Department disallowed the losses claimed by the Horns in relation to the Company, concluding that the losses were disallowed for both federal and State purposes under Internal Revenue Code § 183 (commonly referred to as the “hobby loss rule”), which disallows deductions arising from losses related to activities “not engaged in for profit.”
ALJ Decision. After a hearing, the Administrative Law Judge concluded that, for purposes of applying the hobby loss rule, the commercial production, real estate, and antiques businesses should be treated as separate endeavors, that all were engaged in for profit, and thus all of the losses incurred by the Company were deductible by the Horns as shareholders of the S corporation.
Tribunal Decision. The Tribunal upheld the ALJ decision and allowed the Horns to deduct all of the losses incurred by the Company during the Audit Period. In reaching its decision, the Tribunal first agreed with the ALJ that the Company’s three businesses must each be examined independently for purposes of applying the hobby loss rule, stressing that there was no evidence that the businesses engaged in cross-advertising or other activities that synergistically generated leads or sales for the other or that the companies shared any client base.
Next, the Tribunal examined the activities of the commercial production business and determined that, although the business was winding down during the Audit Period, it was nonetheless carried out for purposes of making a profit. The Tribunal noted that it was undisputed that the commercial production business was historically carried out for a profit and relied on federal case law concluding that a business is allowed a “reasonable time to unwind” without being subject to the disallowance of losses under the hobby loss rule.
Finally, the Tribunal concluded that the antiques and real estate businesses also were not subject to the hobby loss rule’s prohibition on deductions. The Tribunal partially relied on a nine-factor analysis in a federal regulation (Treas. Reg. § 1.183-2(b)), which includes factors such as (a) the manner in which the taxpayer carries on the activity; (b) the expertise of the taxpayer or its advisors in carrying out a business; and (c) the time and effort expended in carrying out a business. The Tribunal added that while such factors may be “useful” in analyzing whether the hobby loss rule is applicable, ultimately “[i]t is the taxpayer’s actual and honest intent to make a profit that renders the activity as having a profit motivation.”
In concluding that the hobby loss rule did not apply to the antiques and real estate businesses, the Tribunal found, among other things, that both businesses were carried out in a “businesslike manner,” and the price for which antiques and real estate properties were sold was significantly greater than the Company’s purchase price for the items and properties. While acknowledging that one of the factors to be considered is the “elements of personal pleasure or recreation,” the Tribunal found that Mrs. Horn’s admission that she enjoyed the antiques business and found it “fascinating” was not determinative, citing federal case law stating that “suffering has never been made a prerequisite to deductibility.”
It does not appear that the IRS ever disallowed deductions claimed by the Horns on the issue of whether the Company’s losses under the hobby loss rule. While the Tribunal rejected the Department’s legal conclusions supporting the assessment of the Horns, this case serves as a reminder that, even if the IRS raises no challenges, the Department can raise issues that arise under federal income tax law principles.
Separately, it is noteworthy that the Department challenged the profit motive for the antiques business led by Mrs. Horn based in part on facts and circumstances that were also historically present in the commercial production business led by Mr. Horn (which, prior to being wound down, was unquestionably engaged in for a profit). For example, the Department argued that the Company’s employment of family members dictated against treating the antiques business as a business engaged in for a profit, even though the Horns also employed family members in its commercial production business. The Tribunal did not find such facts determinative.