TAX COURT OPINION

Case: Alain J. & Carol M. Hanover
Docket Number: 8723-10
Judge: Gustafson
Opinion Type: bench
Filed: 04/18/2011
Pages: 31

CZ UNITED STATES TAX COURT WASHINGTON, DC 20217 ALAIN J. & CAROL M. HANOVER, Petitioners, v. ) Docket No. 8723-10. COMMISSIONER OF INTERNAL REVENUE, Respondent O R D E R Pursuant to Rule 152 (b) , Tax Court Rules of Practice and Procedure, it is ORDERED that the Clerk of the Court shall transmit herewith to petitioners and to respondent a copy of transcript of Gustafson at Boston, Massachusetts, on March 24, 2011, containing his oral conclusion of findings of the trial. the trial fact and opinion rendered at the in the above case before Judge David the pages of the In accordance with the oral findings of decision will be entered for the respondent. fact and opinion, (Signed) David Gustafson Judge Dated: Washington, D.C. April 18, 2011 SERVEDApr182011 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 3 Bench Opinion by Judge David Gustafson March 24, 2011 Hanover v. Commissioner Docket No. 8723-10 THE COURT: The Court has decided to render oral Findings of Fact and Opinion in this case. The following represents the Court's oral Findings of Fact and Opinion, which shall not be relied on as precedent in any other case. This Bench Opinion is made pursuant to the authority granted by section 7459(b) of the Internal Revenue Code of 1986, as amended, and Rule 152 of the Tax Court Rules of Practice and Procedure. By a statutory notice of deficiency dated January 21, 2010, the Internal Revenue Service (IRS) determined deficiencies in the Federal income tax of petitioners Alain J. and Carol M. Hanover for a total of almost $300,000 for tax years 2005, 2006, and 2007, and accuracy-related penalties under section 6662(a) totaling almost $60,000. The issues for decision are (1) whether Mr. Hanover's yacht Activity was an activity not engaged in for profit pursuant to section 183, and (2) whether Mr. Hanover is liable for the accuracy-related penalty of section 6662(a). We find that Mr. Hanover's yacht activity was not engaged in for profit and that he is liable for the penalty. Some of the facts have been stipulated and Heritage Reporting Corporation (202) 628-4888 4 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 are so found. The parties' initial stipulation of facts and its attached exhibits, as well as the parties' supplemental stipulation, are incorporated herein by this reference. Trial of this case was held in Boston, Massachusetts, on March 23 and 24, 2011. We find the following facts: Findings of Fact At the time they filed their petition, Mr. and Mrs. Hanover resided in Massachusetts. Mr. Hanover's background and other business activities Mr. Hanover received his bachelor's degree from the Massachusetts Institute of Technology ("M.I.T.") in 1970 and thereafter received a master's degree from Harvard University. Since then he has had 30 years of successful experience in venture capital, executive management, and engineering. Inc. Magazine named him Entrepreneur of the Year in 1993. He has been on the boards of directors of some 15 companies. In his venture capital and similar investment activities, he has frequently been responsible for making investment decisions involving millions of dollars and, in that connection, for performing "due diligence" examinations of businesses that were prospective investments. In so doing, he regularly obtained from a potential target company its financial Heritage Reporting Corporation (202) 628-4888 5 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 statements, financial projections, and its business plan. But he often observed that the target's own self-evaluations were exaggerated and had to be redone. Mr. Hanover's interest in sailing In college Mr. Hanover "fell in love with sailing". He joined M.I.T.'s sailing team, became a manager of the team, and participated in racing and other sailing events. After college this interest continued. Mr. Hanover occasionally rented boats for use by himself and his family. At one point he owned a 26-foot sailboat. He hoped one day to buy a more substantial boat and spend more time sailing. In 2000 he took concrete steps toward realizing that desire. He became aware of a 12-meter yacht that he decided to purchase. The first 12-meter yacht in which Mr. Hanover took an interest was the Stiarna. It had been built in Britain and was in Trinidad. It was not eligible to be used for charters. Mr. Hanover wanted to use the boat to sail with family and friends and to take business partners and prospects sailing. The Stiarna was in poor condition and needed substantial repair, so Mr. Hanover was able to purchase it for the low price of $130,000, and he arranged to sail it from Trinidad to Heritage Reporting Corporation (202) 628-4888 6 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Granada for the needed repairs. However, on the trip to Granada, the engine caught fire and the Stiarna burned and sank. Mr. Hanover's acquisition of the Columbia Undaunted by the sinking of the Stiarna, Mr. Hanover contacted brokers and told them he was still interested in acquiring a 12-meter yacht. He was made aware of the Columbia, which was for sale in nearby Rhode Island. This boat had won the America's Cup in 1958 and was considered by afficionados to be a particularly beautiful boat. The Columbia was for sale for a much higher asking price than the Stiarna had been--$725,000. Mr. Hanover made a tentative offer of over $600,000, but when he had the boat inspected, the surveyor found problems that called for an estimated $250,000 of repairs. Mr. Hanover eventually agreed to pay $513,000 and purchased the Columbia (through an LLC discussed below), knowing that those major repair expenses awaited him. When he first acquired the Columbia, Mr. Hanover arranged for the performance of the minimal repairs to make the boat charterable for the upcoming season, and he planned for the major repairs to be performed the following winter. We find that, in making the decision to Heritage Reporting Corporation (202) 628-4888 7 1 2 3 4 5 6 7 8 9 purchase the Columbia and use it for chartering, Mr. Hanover did not perform anything like the "due diligence" that he was accustomed to perform for investments with a serious profit motive. He did not claim to have performed any significant research into the state of the yacht chartering business. He did not consult with the owners of any other yacht chartering businesses or any experts in the field. He says that he believed the Columbia had been "nearly 10- - break even" as a charter boat, a belief he says he 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 acquired by reviewing the financial projections of the seller; but he did not offer any such projections into evidence, and he does not give evidence of any of the scrutiny or skepticism with which he viewed the self-evaluations of target companies in his venture capital work. The alleged performance of the previous owner's chartering activity--nearly breaking even--was hardly a selling point to someone interested in making a profit. Mr. Hanover did not prepare any formal or written business plan but alleges, in only the most general terms, that he had a plan only in his head. Mr. Hanover testified that he knew he "would have to put [the Columbia] in a charter business to pay the bills and keep a captain employed. So I knew I had to Heritage Reporting Corporation (202) 628-4888 8 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 make it a business." We find, however, that his intention about the chartering was just that--to help pay the bills. There is no reason to doubt that Mr. Hanover would have been pleased for the chartering business to turn a profit; but any thought of a chartering business was evidently preceded by his determination to own a boat, and the chartering was a subsidiary enterprise, undertaken "to pay the bills", rather than to make profit. Because he "had to make it a business", Mr. Hanover formed "12 Meter Yacht Charters, LLC" ("the LLC") to purchase the Columbia and run the charter activity. Commencement of chartering The previous owner of the Columbia had an agreement with the New York Yacht Club ("NYYC") for its use of the boat for some of the 2000 season and for three months of the 2001 season; and Mr. Hanover acquired the Columbia subject to those charters. For generating other charters, Mr. Hanover decided to retain the same chartering company that the previous owner had used--America's Cup Charters ("ACC"). The previous owner had employed a captain (James Marshall); and, since Mr. Hanover has never been licensed by the Coast Guard to be the captain of a Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 9 commercial charter boat, he employed that same captain. The previous owner had retained a bookkeeper to keep the books for the chartering business, and Mr. Hanover hired the same bookkeeper. After the 2000 season, Mr. Hanover hired a shipwright to do the renovation or "refit" that would make the serious repairs that the Columbia needed, assisted by Captain Marshall. As their work exposed the hidden problems of the boat, they found that the steel ribs or "frames" were all corroded to some extent--some quite seriously--and that the boat had other problems such as rot, which had not been visible before. Upon advice, Mr. Hanover decided that, in addition to the extensive repairs already anticipated, he should not do minimal repairs to these new-found problems but should do the extensive repairs necessary to bring the boat up to its full potential. He ended up paying not the originally estimated $250,000 but approximately $816,000 (bringing his investment in the boat up to, a total of about $1,329,000). However, after that refit, the Columbia was appraised for insurance purposes at only $950,000. Mr. Hanover testified that he has hoped that the Columbia might in fact appreciate in value, since other arguably similar boats ("in pristine condition") have sold for $1.5 Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 million. However, he presented no written evidence of 10 these other boats' values, and offered no expert appraisal or other information about any increased value (or an expectation of increased value) of the Columbia. We find that any hopes he had about appreciation in the value of the Columbia were not seriously arrived at and did not inform his decision-making in any serious way. The refit was successful, however, and in the 2001 season the boat performed well for the NYYC, who chartered the boat to participate in the 150th anniversary America's Cup Jubilee Regatta in England. The NYYC paid for certain additional improvements on the boat. Formation of Classic The 2002 season, however, was a very poor chartering season for the Columbia and for two other boats whose charters were managed by ACC. 12-meter yachts are chartered for various sailing circumstances--regattas (discussed below) and periods as short as a few hours. Mr. Hanover and the owners of the other two boats came to realize that the owners of ACC gave preferential allocation of charters to boats that they owned themselves. Mr. Hanover and the other two dissatisfied owners decided to start their Heritage Reporting Corporation (202) 628-4888 | 11 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 own chartering company. They each contributed $30,000 and formed "Classic 12 Meter Charters" ("Classic"), an S-Corporation, with the agreement that Classic would allocate charters evenly among the three shareholders' boats and would earn a commission on each booking. Another capital contribution was needed the next year. Mr. Hanover and one of the other shareholders contributed another $20,000. The third shareholder was unwilling to make an additional contribution, so soon thereafter the other two bought him out, and thereafter Classic managed only two boats and had two shareholders--Mr. Hanover and Jeffrey Barrows, owner and frequent captain of the Heritage. Attempts to increase charters In the succeeding years Classic tried various means of promoting their charters. Classic advertised with a website of its own, advertisements on other websites, an email newsletter, flyers, signs, and attendance at trade shows and smaller events. Classic sold nautical gear and clothing with logos of their boats. At one point Classic began selling charters not only to an individual or entity that pays the entire charter fee (which is typical in the business) but also to a group of individuals who purchase "tickets" to participate. Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 12 However, in terms of profiting from increased charters Mr. Hanover was always at a disadvantage, even vis-à-vis his Classic co-shareholder, since he was not a licensed captain and could not perform his own repairs. His colleague--Jeffrey Barrows--is a captain and does his own repairs, and he is able to save substantially as a result. But even so, Mr. Barrows testified that his profits are marginal at best. However, Mr. Barrows's status as his own captain did make it easier for him to attempt "ticket" sales when that strategy was new and not yet profitable (because paying passengers per cruise were few), whereas Mr. Hanover's cost of paying a captain would have made it more problematic for him to use ticket sales. Regattas One of the major occasions for using a 12-meter yacht is in regattas (races), and Classic charters Columbia to customers who want to use it in regattas. If the boat competes and wins in regattas, then the ability to find charter customers for a 12-meter yacht may be improved, since potential customers like to have a winning boat. If the LLC has no paying customer for a given regatta, Mr. Hanover has been able on rare occasion to put together a group Heritage Reporting Corporation (202) 628-4888 13 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 of disparate individuals each of whom is willing to pay to participate (rather than an already organized common group). But when, in the absence of a conventional charter, he is unable to put together such a group, as is more typical, Mr. Hanover usually participates in the regatta with unpaid volunteers. There is some advantage to having the boat participate in a regatta even if it has no paying customer (and the LLC must- therefore bear the costs of the event), since the boat is exposed to the public, and for this reason Mr. Hanover has sometimes instructed his captain and crew to attend a regatta that he could not attend. However, the revenue-generating purpose of these unchartered regattas is exaggerated in Mr. Hanover's description. While some of the witnesses were able, with difficulty, to recall a specific instance in which regatta participation did lead to a charter, Mr. Hanover did not show any actual quantum of revenue that this advantage supposedly accrues. Personal use of the Columbia When Mr. Hanover participates in a regatta, he is the "skipper" of the Columbia, i.e., the man at the wheel (not the captain), and is listed as such in the public information about the regatta. In a lawsuit against the insurer of the Stiarna, Mr. Heritage Reporting Corporation (202) 628-4888 14 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Hanover testified that, right from the start, his intention for the Columbia included use by family and friends. One weekend each summer (except in 2007), Mr. and Mrs. Hanover host an annual "family sail" for their family and friends. On other occasions, Mr. Hanover or another member of his family takes the boat out for a short cruise (with the LLC bearing the expense of the mandatory captain and crew). About once a year he brought the Columbia to Boston for personal use (a trip that usually lasted 4 to 5 days, and in one year, for as long as a week). Mr. Hanover denies that the unpaid volunteer team that sometimes staffs the boat with him are his friends, and we assume it is true that he does not socialize with them outside of the sailing context. However; another witness (Columbia's current captain) did refer to these volunteers as Mr. Hanover's friends, and in fact it seems inevitable that this characterization is correct. He and they are a group who regularly and voluntarily get together to do something that they enjoy. This is one form of friendship, and sailing gave Mr. Hanover this wholesome, personal benefit. Mr. Hanover testified that personal use of the boat always give way when there is a paying Heritage Reporting Corporation (202) 628-4888 15 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 customer available. However, his instruction to this effect in an email to the scheduler was odd: "Charters come first, as I'm trying to be profitable, and make my IRS case". At the time of that email, profit-making seems to have been a means to the end of tax avoidance rather than a principal end in itself. Moreover, this alleged priority for charters was not always borne out. On one occasion, when Mr. Hanover's son wanted to use the boat personally, Mr. Hanover instructed Classic, "Don't work too hard on getting a charter" that would preempt his son. Mr. Hanover acknowledged that he would not cancel a regatta in which he participated without paying customers in order to hire the boat out for a mere afternoon sail. Financial performance of the charter business Mr. Hanover's charter business has never made a profit. The records of the LLC, maintained with the use of the Quickbooks program by a bookkeeper, were generally accurate'(with an exception discussed below), and they show that Mr. Hanover had an intention of keeping track of money in and money out. The information from those records was used to prepare the tax returns filed by the LLC for 2002 through 2009. Those returns show substantial losses in every year--from a low of $122,795 in 2008 to a Heritage Reporting Corporation (202) 628-4888 16 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 high of $299,736 in 2003. The losses over those eight years total $1,760,012, or $220,001 per year. The LLC's bookkeeper prepared profit and loss statements for Mr. Hanover at least annually, but there is no evidence that he considered this data in any attempt to make the hard decision of whether the business would ever really be profitable. Rather, the continuation of the business was assumed, and the financial questions entertained were what to spend and whether revenue could be increased. At trial Mr. Hanover stated that those numbers are not reliable and that "I don't know what the real profit or loss was". In an attempt to mitigate the significance of the reported losses, Mr. Hanover pointed out errors, recently discovered, in the bookkeeping entries from which the tax return information was derived. He alleges that the accounting for his own payments toward charter expenses (mistakenly recorded as contributions to capital) resulted in understatements of the revenues of the LLC--but he does not quantify the amounts of those understated revenues. Moreover, it appears that an over-correction of that error in 2008 and 2009 may have exaggerated revenues in those later years, in which his contributions to capital were evidently Heritage Reporting Corporation (202) 628-4888 17 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 mischaracterized as revenue. However, the principal significance of the errors and their correction--even if they are explained in the light most favorable to Mr. Hanover--is not what he argues. Rather, he has demonstrated that for all of the years of the LLC's operation, its records have been materially unreliable in reporting the revenues and the profit or loss of the LLC. Yet despite his high level of financial sophistication, Mr. Hanover did not spot these errors until this tax controversy arose. Mr. Hanover did not show that he uses his records or their data to evaluate the performance of his chartering activity. I. Section 183 OPINION A taxpayer who is carrying on a trade or business may deduct ordinary and necessary expenses incurred in connection with the operation of the business. Sec. 162(a). However, a taxpayer cannot reduce his taxable income by claiming as deductions the expenses he incurs for his hobby or other non-profit activity. Section 183(a) provides generally that if an activity is not engaged in for profit, no deduction attributable to such activity shall be allowed except as provided in section 183(b). Heritage Reporting Corporation (202) 628-4888 18 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Generally, the IRS's deficiency determinations set forth in a notice of deficiency are presumed correct, and the taxpayer bears the burden of showing the determinations are in error. Rule 142(a). Thus, if the IRS determines that a given yacht-chartering activity is not engaged in for profit, that determination is presumed correct, and the taxpayer has the burden to prove otherwise. Section 183 (c) defines an "activity not engaged in for profit" as "any activity other than one with respect to which deductions are allowable for the taxable year under section 162 or under paragraph (1) or (2) of section 212. " An activity constitutes a "trade or business" within the meaning of section 162--and it thus escapes the limitation of section 183--if the taxpayer's actual and honest objective is to realize a profit. Osteen v. Commissioner, 62 F.3d 356, 358 (11th Cir. 1995), affg. in part and revg. in part T.C. Memo. 1993-519. The expectation of profit need not have been reasonable; however, the taxpayer must have entered into the activity, or continued it, with the objective of making a profit. Hulter v. Commissioner, 91 T.C. 371, 393 (1988); 26 C.F.R. sec. 1.183-2(a),M Regs. Whether the requisite profit objective exists is determined by Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 19 looking at all the surrounding facts and circumstances. Keanini v. Commissioner, 94 T.C. 41, 46 (1990). Greater weight is given to objective facts than to a taxpayer's mere statement of intent. Thomas v. Commissioner, 84 T.C. 1244, 1269 (1985), affd. 792 F.2d 1256 (4th Cir. 1986). 26 C.F.R. section 1.183-2(b), from the Regulations, provides a ' list of factors to be considered in the evaluation of a taxpayer's profit objective: (1) The manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity 'may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer's history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, from the activity; (8) the financial status of the taxpayer; and (9) elements of personal pleasure or recreation. This list is nonexclusive, and the number of factors for or against the taxpayer is not necessarily determinative, but rather all facts and circumstances must be taken into account, and more weight may be Heritage Reporting Corporation (202) 628-4888 20 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 given to some factors than to others. See Dunn v. Commissioner, 70 T.C. 715, 720 (1978), affd. 615 F.2d 578 (2d Cir. 1980). We now address these 9 factors. 1. Manner in which the activity is conducted The fact that a taxpayer carries on the activity in a business-like manner and maintains complete and accurate books and records may indicate a profit objective. 26 C.F.R. sec. 1.183-2(b) (1). Records no more sophisticated than the LLC's Quickbooks records could be fully adequate to meet this standard. However, many households track their income and spending with the same care (and even the same tools) that Mr. Hanover demonstrated in the case of Classic and the LLC, but they do not thereby become for-profit enterprises. Moreover, the lack of business-like character shows itself in this case both in the significant errors that rendered the records misleading on the activity's profit or loss and--more important--in Mr. Hanover's unawareness of those errors until the IRS began examining him. It appears that errors in measuring the losses of the LLC did not actually matter, because Mr. Hanover was engaging in the yacht activity regardless of what the facts would have showed him about the unprofitability of that Heritage Reporting Corporation (202) 628-4888 I 21 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 activity. Some taxpayers with informal or unwritten business plans do have an intent to make a profit, but given Mr. Hanover's extremely high level of financial sophistication, his lack of any written projections for or evaluations of the yacht activity is strong evidence that he was not seeking profit. When Mr. Hanover wants to do due diligence, he knows how to do it; he did not do it here. He did no market research. When he was curious about the relative success of his competitors, his method of getting information--quite unlike the methods he surely must use in his business ventures--was simply to ask his employees about the frequency of the comings and goings of the other boats. Mr. Hanover simply did not approach the yacht activity the way that he would have approached a business proposition. Rather, he pursued it the way someone pursues what he loves. We conclude that this factor--the manner in which the activity is conducted--is strongly against Mr. Hanover and indicates that he did not have the requisite profit motive. ' Mr. Hanover stresses, however, that he and his LLC worked hard to cut costs and that Classic made various attempts to increase revenue, and he Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 22 established at trial that they did. It is certainly true that the absence of such efforts is evidence of a lack of profit motive; and their presence can be some evidence of a profit motive; but efforts to cut cost and raise revenue do not necessarily establish or even tend to show profit motive. As for cutting costs, a wise hobbyist with no thought at all of receiving any revenue at all will nonetheless try to keep down the cost of his hobby. Owning and sailing a 12-meter boat is a complex undertaking; some do it without any chartering activity, but surely the sensible ones scrutinize and try to minimize their costs. That discipline does not convert a hobby into a business. As for increasing revenue, Mr. Hanover did demonstrate that Classic made various changes to its methods over the years (such as the promotional efforts described above, the initiation of the clothing line, and seeking out new business from cruises and in Long Island sound), so we think he showed that he did genuinely desire to increase the number of charters. However, some expensive hobbies do generate revenues for practitioners who have no intention of ever making a profit but who want to minimize their losses by maximizing whatever revenue Heritage Reporting Corporation (202) 628-4888 23 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 they can get. The desire to reduce losses--which desire Mr. Hanover did demonstrate--is simply not the same thing as the objective of making a profit, which he did not demonstrate. 2. Expertise of the taxpayer and his advisers A taxpayer's expertise, research, and study of an activity, as well as his consultation with experts, may be indicative of a profit motive. 26 C.F.R. sec. 1.183-2(b) (2), -Proœd----E-A&wi:&. Regs. Mr. Hanover consulted no experts and talked with no other yacht charterers before buying the Columbia. He seems to have been a competent amateur sailor, but there is no evidence to suggest he had any expertise pertinent to the business of chartering boats, nor that he consulted anyone with that expertise. We conclude that this factor--expertise--is against Mr. Hanover and indicates that he did not have the requisite profit motive. 3. Time and effort expended Mr. Hanover did spend substantial amounts of time on the yacht. However, he earned his living by regular employment in other work, and he did not quantify the time he spent on the business end of chartering. If a taxpayer works full-time at another job, this makes it less likely that a profit motive is Heritage Reporting Corporation (202) 628-4888 24 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 behind the secondary activity. See 26 C.F.R. sec. 1.183-2(b) (3). We do not have jurisdiction, occasion, or sufficient information to decide whether Hanover's colleague at Classic was engaged in yacht chartering for profit; but the comparison of the two men is illuminating. Mr. Barrows did have another job (residential real estate) that evidently provides his livelihood, but unlike Mr. Hanover, Mr. Barrows served as captain on unglamorous cruises, did repair work himself, and made himself available for loss-leader "ticket" sales, in an attempt to get this new line of business operating. The record shows that Mr. Hanover, on the other hand, spent his time behind the wheel at regattas. We consider this factor--time and effort expended--to be against Mr. Hanover. 4. The expectation that assets may appreciate in value Mr. Hanover alleges that he hoped the Columbia might attain a value of as much as $1.5 million, which (depending on when that value was realized) could have been a considerable gain above his total investment of $1,329,000. Or, if we posit that he had this hope in 2000 when he anticipated a Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 25 total investment (purchase price of $513,000 plus $250,000 in repairs) of only $763,000, then the gain would be impressive. However, Mr. Hanover's sophistication works against him in this factor. A person like Mr. Hanover, deciding to start a business because an asset was thought likely to appreciate, would have made serious inquiries that he could now document or at least describe in detail. But he presented no evidence of serious, contemporaneous appraisal or evaluation of the prospect of increased value. He presented only a retrospective and completely unverified and unverifiable allegation that he subjectively hoped the boat might appreciate; and the specific data on which that hope was based--i.e., the values of two allegedly equivalent boats--was not substantiated by any evidence other than Mr. Hanover's testimony. This factor does not favor Mr. Hanover. 5. The taxpayer's success in similar or dissimilar activities Mr. Hanover is a successful entrepreneur who has succeeded in a variety of businesses, though none of those businesses has any particular resemblance to yacht chartering. And while he showed at trial that he is a competent sailor, he made no showing that the Heritage Reporting. Corporation (202) 628-4888 26 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 particular activity of running a chartering business bore any relation to his skill set. We conclude that this factor is neutral and does not show whether or not Mr. Hanover had the requisite profit motive. 6-7. History of income or loss / amount of gain In the years at issue, and in the prior and succeeding years, Mr.. Hanover's LLC reported on its tax returns an impressive string of losses from the yacht activity. A record of substantial losses over several years may be indicative of the absence of a profit motive. Golanty v. Commissioner, 72 T.C. 411, 426 (1979), affd., 647 F.2d 170 (9th Cir. 1981). This factor weighs against Mr. Hanover in assessing his profit motive. At trial Mr. Hanover observed that, if depreciation is disregarded, then the cash flow from the activity is positive in later years. According to the figures on the LLC's returns, it is true that disregarding depreciation yields positive cash flow of $4,951 in 2008 and $19,407 in 2009. However, these very modest amounts are dwarfed by the negative cash flows overall. Total losses for the eight years total $1,760,012, and if they are reduced by the depreciation reported on the LLC's returns for 2002 through 2009, which totals $870,016, the net result is Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 27 still negative cash flow of $889,996 (i.e., an average negative cash flow of $111,250 per year for 8 years). Moreover, the two years in which this analysis yields an apparent positive cash flow are the very years in which bookkeeping errors overstated revenues. The yacht activity's losses speak strongly against any profit motive. 8. Financial status of the taxpayer Substantial income from sources other than the activity in question, particularly if offset by substantial tax benefits, may indicate the activity is not engaged in for profit. 26 C.F.R. sec. 1.183- 2(b) (8), -Frused. & Admiu. Regs. Mr. Hanover had / substantial income from other sources. Without the claimed losses from the yacht activity, Mr. Hanover's taxable income would have been significantly higher. This factor tends against Mr. Hanover's claim of a profit motive. 9. Elements of personal pleasure The absence of personal pleasure or recreation relating to the activity in question may indicate the presence of a profit objective. 26 C.F.R. sec. 1.183-2(b) (9), frore&-t-Adm-i-H.. Regs. Mr. Hanover, however, candidly confesses to having fallen in love with sailing as a young man, and he Heritage Reporting Corporation (202) 628-4888 28 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 evidently obtains great pleasure from being the skipper of the Columbia. We conclude that this factor--elements of personal pleasure--is against Mr. Hanover and indicates that he did not have the requisite profit motive. Of course, the mere fact that a taxpayer derives personal pleasure from a particular activity does not, per se, demonstrate a lack of profit motive. There are fortunate people who love their work. But in this instance, Mr. Hanover's willingness to spend $1.3 million to acquire and refit a boat and to lose over $100,000 per year in negative cash flow is sharply at odds with this claim of a profit motive. II. Section 6662(a) A. General principles Section 6662 imposes a 20-percent penalty on an underpayment of tax that results either from negligence or disregard of rules and regulations or from a substantial understatement of income tax. See sec. 6662(a), (b) (1) and (2). By definition, an understatement of income tax is substantial if it exceeds the greater of $5,000 or 10 percent of the tax required to be shown on the return. Sec. 6662(d) (1). Pursuant to section 7491(c), the Commissioner bears the burden of producing sufficient evidence showing Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 29 the imposition of the penalty is appropriate in a given case. Higbee v. Commissioner, 116 T.C. 438, 445 (2001). Once the Commissioner meets this burden, the taxpayer must come forward with persuasive evidence that the Commissioner's determination is incorrect. Rule 142(a); Higbee v. Commissioner, supra at 447. A taxpayer otherwise liable for the accuracy-related penalty may avoid the liability by successfully invoking one of three other provisions: Section 6662(d) (2) (B) provides that an understatement may be reduced, first, where the taxpayer had substantial authority for his treatment of any item giving rise to the understatement, or, second, where the relevant facts affecting the item's treatment are adequately disclosed and the taxpayer had a reasonable basis for his treatment of that item. Third, section 6664(c) (1) provides that a taxpayer may avoid liability for the accuracy-related penalty to the extent that he demonstrates that he had reasonable cause for that portion of the underpayment and that he acted in good faith with respect to that portion. 26 C.F.R. sec. 1.6664-4(b) (1), Income Tax Regs. B. Application to Mr. Hanover 1. Substantial Understatement As a result of deducting the yacht activity Heritage Reporting Corporation (202) 628-4888 30 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 loss from his gross income, Mr. Hanover reported greatly reduced taxable income and tax liabilities for 2005, 2006, and 2007. The IRS determined in each year an understatement greater than $5,000 and greater than 10 percent of the tax liability that Mr. Hanover reported. Respondent has thus carried the burden of production imposed by section 7491(c). The accuracy-related penalty is mandatory; the statute provides that it "shall be added". Sec. 6662(a). Mr. Hanover bears the burden of proving any defenses, such as substantial authority, disclosure and reasonable basis, and reasonable cause and good faith. See Higbee v. Commissioner, supra at 446. 2. Defenses A taxpayer who is otherwise liable for the accuracy-related penalty may avoid the liability if he successfully invokes one of three other provisions: a. First, section 6662(d) (2) (lB) provides that an understatement may be reduced where the taxpayer had substantial authority for its treatment of any item giving rise to the understatement. There is no authority that would warrant Mr. Hanover's position. b. Second, section 6662(d) (2) (JB) provides that an understatement may be reduced where the relevant facts affecting the item's treatment are adequately Heritage Reporting Corporation (202) 628-4888 31 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 disclosed and the taxpayer had a reasonable basis for its treatment of that item. Neither of these criteria is met here. The facts that show Mr. Hanover's lack of profit motive were not disclosed on his return; reflecting the activity as a for-profit "business" was not reasonable in light of the facts and circumstances. c. Third, section 6664(c) (1) provides that, if the taxpayer shows that there was reasonable cause for a portion of an underpayment and that it acted in good faith with respect to such portion, no accuracy related penalty shall be imposed with respect to that portion. Whether the taxpayer acted with reasonable cause and in good faith depends on the pertinent facts and circumstances, including its efforts to assess its proper tax liability, its knowledge and experience, and the extent to which it relied on the advice of a tax professional. 26 C.F.R. sec. 1.6664-4(b) (1), Income Tax Regs. Mr. Hanover alleges no reliance on professional advice, and he put on no evidence as to any attempts to comply with the tax laws and pay his proper tax. Conclusion We conclude that Mr. Hanover did not engage in the yacht activity during tax years 2005, 2006, and Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 32 2007 with the actual and honest objective of making a profit, and that section 183 is therefore applicable in this case; and we conclude that he is liable for an accuracy-related penalty pursuant to section 6662(a). To reflect the foregoing, decision will be entered for the respondent. This concludes the Court' s oral Findings of Fact and Opinion in this case. (Whereupon, at 3:25 p.m., the bench opinion in the above-entitled matter was concluded.) // // // // // // // // // // // // // // // Heritage Reporting Corporation (202) 628-4888