section 6694 and the hobby loss issue

The IRS fact sheet below on the bobby-loss/business-loss issue comes up frequently. There are all forms of side businesses for a large part of the US population, and these side businesses have been multiplying conmmensurate with internet commerce.
Any side businss raises a section 6694 issue. The IRS is tough on these issues and there is a large body of case law that deals with these issues. When I have an examination business-deduction/hobby-loss issue, I defend the business deductions with case law that reached a favorable result. This issue is often resolved with good advocacy and an effective legal memorandum. There are some 6694/hobby-loss caases under the pre-2008 penalty provisions. Expect many proposed section 6694 penalties to be assessed by the IRS in connection with this issue. The IRS has always taken aggressive positions in deeming valid businesses to be mere hobbies. There is the new incentive for the IRS to reach an adverse result, motivated by the very large section 6694 penalty.


IRS Fact Sheet FS-2008-23

August 21, 2008

Code Sec. 183

Individuals : Hobby loss rule : Trade or business .



Is Your Hobby a For-Profit Endeavor?



FS-2008-23, June 2008



CONCLUSIONS OF LAW


1. The jurisdiction of this court is invoked pursuant to 28 U.S.C. §1346(a)(1).


2. Section 6694(a) imposes a penalty of $100 against any income tax return preparer whose negligent disregard of IRS rules and regulations results in an understatement of tax liability. 3 26 U.S.C. §6694(a) ; Brockhouse v. United States [84-2 USTC ¶10,005 ], 749 F.2d 1248, 1251 (7th Cir. 1984); Sansom v. United States [88-2 USTC ¶9422 ], 703 F.Supp. 1505, 1510 (N.D. Fla. 1988). The purpose of Section 6694(a) is to deter preparers from engaging in abusive practices that reduce taxable income. Brockhouse, 749 F.2d at 1252; Swart v. United States [83-2 USTC ¶9545 ], 568 F.Supp. 763, 765 (C.D.Cal. 1982). Because Section 6694(a) imposes a penalty, its terms must be construed strictly. Commissioner v. Acker, [59-2 USTC ¶9757 ], 361 U.S. 87, 91 (1959); F.C.C. v. American Broadcasting Co., 347 U.S. 284, 296 (1954).


3. The negligence penalties imposed on Goulding are presumptively valid. United States v. Janis [76-2 USTC ¶16,229 ], 428 U.S. 433, 440 (1976); Ruth v. United States [87-1 USTC ¶9408], 823 F.2d 1091, 1093 (7th Cir. 1987). Accordingly, Goulding bears the burden of proving the absence of negligence. Janis, 428 U.S. at 440; Brockhouse, 749 F.2d at 1251.


4. Negligence in the context of Section 6694(a) is defined as a lack of due care or failure to do what an ordinary and reasonably prudent person would do under the circumstances. Brockhouse, 749 F.2d at 1251; Zmuda v. Commissioner [84-1 USTC ¶9442 ], 731 F.2d 1417, 1422 (9th Cir. 1984); Marcello v. Commissioner [67-2 USTC ¶9516 ], 380 F.2d 499, 506 (5th Cir. 1967), cert. denied, 389 U.S. 1044 (1968). The standard of care applicable under Section 6694(a) requires preparers to exercise due diligence. Brockhouse, 749 F.2d at 1251-52; Sansom, 703 F.Supp. at 1510. This means the preparer must act as a reasonable, prudent person with respect to the information at hand. Id. Under this standard, the preparer must evaluate the implications of relevant information and seek additional information if there is any doubt the return is not in compliance with IRS rules or regulations. Id. In the case of a partnership engaged in a tax shelter, it is unreasonable for the preparer not to obtain independent verification that the return complies with IRS rules and regulations. Zmuda, 731 F.2d at 1422. 4


5. The regulations to Section 6694(a) provide preparers with a reasonable basis exemption from Section 6694(a) 's penalties:


If a preparer in good faith and with reasonable basis takes the position that a rule or regulation does not accurately reflect the Code and does not follow it, the preparer has not negligently or intentionally disregarded the rule or regulation.


Treas. Reg. §1.6694-1(a)(4) . The reasonable basis exemption set forth in these regulations applies only where the preparer is engaged in a dispute about an IRS interpretation of a rule or regulation applicable to a provision of the return. Druker v. Commissioner [83-1 USTC ¶9116 ], 697 F.2d 46, 55 (2d Cir. 1982) (Friendly, J.), citing, H.R. Rep. No. 658, 94th Cong. 1st Sess. 278 (1975), U.S. Code Cong. & Admin. News 2897, 3174 (1976). This exemption is inapplicable to this case. Goulding is not engaged in a dispute with the IRS over the lawfulness of rules and regulations applicable to the partnership or limited partner returns. The dispute here is whether Goulding acted as a reasonably prudent person with respect to the information available to him. Brockhouse, 749 F.2d at 1251-52.


6. The uncontroverted evidence shows that Goulding negligently disregarded IRS rules and regulations by creating deductions that failed to qualify under applicable sections of the Internal Revenue Code ("the Code"). 26 U.S.C. §1 et seq.


7. Goulding deducted the partnerships' accounting, legal and management fees under 26 U.S.C. §162(a)(1) . 5 Section 162(a)(1) , in conjunction with 26 U.S.C. §703(a) 6 permits a partnership to claim as a deduction, all ordinary and necessary expenses incurred during the taxable year in carrying on a trade or business, including a reasonable allowance for personal services actually rendered. 26 U.S.C. §162(a)(1) . Section 162 provides a deduction only for ordinary and necessary business expenses incurred during the life of a business. Fishman v. Commissioner [88-1 USTC ¶9137 ], 837 F.2d 309, 312 (7th Cir. 1988); Madison Gas & Electric Co. v. Commissioner [80-2 USTC ¶9754 ], 633 F.2d 512, 517 (7th Cir. 1980). "Pre-operating" or "start-up" costs are not deductible. Id. There is no dispute that the legal services provided by Goulding, for which the partnerships claimed a deduction of over $300,000 in 1979, pertained exclusively to negotiating and drafting various partnership agreements. These agreements enabled the partnerships to commence business. By definition, the legal fees paid to Goulding were nondeductible pre-operating costs. Id. It is also undisputed that Morris D. Ziegler & Co. rendered no accounting services to the partnerships. Therefore, Goulding had no reasonable basis to deduct accounting costs. Id. This leaves only the question of the management fees. Goulding claims that in 1979 the partnerships incurred deductible management fees of $200,000. However, the partnerships did not commence business until the last week of December 1979. There is no evidence that the general partners provided the partnerships with $200,000 in management services in just seven days. There is also no evidence that the general partners provided management services in 1980 or 1981. During these years, National Patent, and not the general partners, had sole responsibility for managing the partnerships' principal business activity--research and development of the acquired technologies. Therefore, Goulding lacked a reasonable basis for deducting management fees.


8. The deductions computed by Goulding under Section 162 are the result of a failure to exercise due care. Based on his knowledge and experience as an attorney, certified public accountant and former IRS agent, Goulding knew or should have known that the legal services he provided constituted nondeductible pre-operating expenses. And based on his extensive involvement in the affairs of each partnership, a reasonable inference may be drawn that Goulding knew or should have known that Morris D. Ziegler & Co. performed no accounting services and that the general partners performed no management services. At a minimum, Goulding had a duty to inquire whether these individuals in fact performed these services. Goulding failed to make this inquiry. A reasonably prudent person faced with the same circumstances would not have claimed the accounting, legal and management fees as deductions on the partnerships' returns. Brockhouse, 749 F.2d at 1251-52.


9. Goulding amortized the cost of the acquisition agreements under 26 U.S.C. §167(a)(1) . 7 Section 167(a)(1) permits investors to amortize or deduct the purchase price of an asset used in a trade or business, or held for the production of income. 26 U.S.C. §167(a)(1) ; Durkin v. Commissioner [89-1 USTC ¶9277 ], 872 F.2d 1271, 1276 (7th Cir. 1989); Estate of Franklin v. Commissioner [76-2 USTC ¶9773 ], 544 F.2d 1045, 1047 (9th Cir. 1976). Section 465(a) of the Code, 26 U.S.C. §465(a) , imposes an "at-risk" requirement on deductions claimed under Section 167 . 8 Section 465 provides that investors may not deduct more than the amount that they are personally liable to repay. Durkin, 872 F.2d at 1276; United States v. Kelley [89-1 USTC ¶9132 ], 864 F.2d 569, 571 (7th Cir. 1989); Levin v. Commissioner [87-2 USTC ¶9600 ], 832 F.2d 403, 408 (7th Cir. 1987). The application of Section 465 to Section 167 means that deductions are predicated upon investment, and not upon ownership. Durkin, 872 F.2d at 1276; Estate of Franklin, 544 F.2d at 1049. This means that investors may not deduct from the cost basis of an asset any portion of the purchase price that is contingent and unlikely to be paid. Durkin, 872 F.2d at 1276.


10. Evidence of a contingent purchase price exists (1) where the purchase price is to be paid out of proceeds from the exploitation of the asset, (2) the investor is sheltered from personal liability because the debt is non-recourse and (3) the purchase price of the asset unreasonably exceeds its fair market value. Id. Each of these conditions is present in this case. The inventors' sales warranties conditioned the contingent component of the acquisition agreements upon successful exploitation of the technologies. The fact that 98 percent of the cost of these technologies was contingent upon a multimillion dollar sales warranty reveals that the purchase price of these technologies far exceeded their fair market value. The undisputed evidence shows that on the date of acquisition, none of these technologies had a reasonable chance of producing the multimillion dollar sales guaranteed by each warranty. Trial II Tr. at 245-53. Barrows Dep. at 15-18; Rappaport Dep. at 15, 39, 53. The inventors had no reasonable expectation of ever receiving the amounts set forth in the acquisition agreements. Id. And the partnerships had no incentive to pay fair market value because a higher purchase price guaranteed a larger tax deduction. In addition, the substance of the acquisition agreements reveals no residual value to these technologies beyond the $7500 paid to each inventor. This conclusion is reinforced by the fact that none of the limited partners was at-risk for a greater amount. Although the assumption agreements required the limited partners to assume the full amount of the partnerships' debt to the inventors, these agreements relieved the limited partners of liability if the unrealistic multimillion dollar sales warranties failed to materialize. Kelley, 864 F.2d at 571. This gave the partnerships an incentive to negotiate an unreasonably high purchase price, far in excess of fair market value. Durkin, 872 F.2d at 1277; Kelley, 864 F.2d at 571.


11. Goulding failed to exercise due care or act in good faith when he relied on the various partnership agreements, offering memoranda and appraisal letters to compute the partnerships' amortization deductions.


The appraisal letters did not provide estimates of fair market value on the date of purchase. The uncontroverted testimony of William Raby, David Rappaport and Joseph Barrows shows that a reasonably prudent person would not have relied on the appraisal letters to compute the amortizable basis of the partnership technologies. Even Goulding's rebuttal witness, Ray Snyder, testified that he could not determine the fair market value of the partnership technologies based on these letters. Trial II Tr. at 347-48, 354.


The partnership agreements and partnership offering memoranda are Goulding's own work product. He virtually had exclusive control over their content. It is disingenuous for Goulding to claim that these documents provided him with an independent source of information. Clearly they did not. Even assuming that Goulding did not prepare the partnership agreements and offering memoranda, a reasonably prudent person would not have relied upon them. The unlikelihood of any sales materializing is readily apparent from the research and development agreements. Those agreements provide a June 30, 1981 cut-off date for research and development. The cut-off date should have alerted Goulding to the fact that amortizing the entire cost basis of the technologies was unreasonable. Also, Goulding amortized the acquisition agreements in accord with the partnerships' right to receive royalty income under the exclusive license agreements. But the license agreements provide that the partnerships are entitled to royalties only out of patented technologies, or technologies with patents pending. Although Goulding testified that four technologies had patents, there is no reliable evidence that the partnership technologies were patented or had patents pending. Accordingly, a reasonably prudent person would not have relied on the license agreements to adopt a method of amortization.


Finally, the offering memoranda warned investors that an IRS audit was probable. Goulding knew this better than anyone else involved with the partnerships. His background as an IRS agent and his acknowledged familiarity with the Code, including Section 6694(a) , should have alerted him to the likelihood of an audit. Consequently, Goulding had a duty to evaluate all available information and seek additional advice on the propriety of the amortization deductions. He failed to make this inquiry and thus acted negligently. Brockhouse, 749 F.2d at 1251-52.


12. Goulding has not met his burden of proving the absence of negligence. Goulding negligently prepared a substantial portion of the tax returns filed by the limited partners of Mercon, Ltd., LaSala, Ltd. and Jonquil, Ltd., and he is liable for penalties due under 26 U.S.C. §6694(a) . Accordingly, judgment is entered for the United States and against Randall S. Goulding.


1 On direct examination, Goulding disclaimed responsibility for any role in the preparation of these documents. The court finds that Goulding's testimony is self-serving and unworthy of credence. His testimony in this trial is directly contradicted by his prior deposition testimony and by his testimony in the first trial. See infra Findings of Fact ¶19. Goulding's lack of credibility is further underscored by his demeanor and his evasive and unresponsive answers on cross-examination.


2 The license agreement applied the 30 percent rate to the following percentages of applicable rates: 1979, 100 percent; 1980, 87.5 percent; 1981, 69 percent; 1982, 50.5 percent. Id. This formula produced a decline in the applicable sales basis of 12.5 percent from 1979 to 1980, 18.5 percent from 1980 to 1981, and 18.5 percent from 1981 to 1982. Id.


3 Section 6694(a) provides:


If any part of any understatement of liability with respect to any return or claim for refund is due to the negligent or intentional disregard of rules and regulations by any person who is an income tax return preparer with respect to such return or claim, such person shall pay a penalty of $100 with respect to such return or claim.


4 Zmuda was decided under 26 U.S.C. §6653(a). That section prohibits the negligent or intentional disregard of IRS rules and regulations by individual taxpayers preparing their own return. There is no distinction between the standard of care applicable to Section 6653(a) and the standard applicable to Section 6694(a) . Brockhouse, 749 F.2d at 1251-52, citing Zmuda, 731 F.2d at 1422. See Drucker v. Commissioner [83-1 USTC ¶9116 ], 697 F.2d 46, 55 (2d Cir. 1982) (Friendly, J.).


5 Section 162(a)(1) provides:


(a) IN GENERAL.--There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including--


(1) a reasonable allowance for salaries or other compensation for personal services actually rendered.


6 Section 703(a) provides in part:


(a) INCOME AND DEDUCTIONS.--The taxable income of a partnership shall be computed in the same manner as in the case of an individual . . . .


7 Section 167(a)(1) provides:


(a) GENERAL RULE.--There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)--


(1) of property used in the trade or business.


8 Section 465(a)(1) provides in part:


(a) LIMITATION TO AMOUNT AT RISK.--


(1) IN GENERAL.--In the case of--


(A) an individual . . .


engaged in an activity to which this section applies, any loss from such activity for the taxable year shall be allowed only to the extent of the aggregate amount with respect to which the taxpayer is at risk . . . for such activity at the close of the taxable year.