Drag Racing and Amway - Fun Not Profit

Originally Published on forbes.com on July 26th,2011

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The case of Richard Zenzen is the most recent “hobby loss” case that I have seen.  Mr. Zenzen seems to have had an appreciation for fast cars and an ability to work on them:

In 1999 petitioner purchased a 1978 Chevrolet Corvette for $10,000 to race. 

In 2004 petitioner purchased a 1989 Chevrolet IROC-Z28 for $11,000, also to race. Petitioner replaced this car’s engine with a used 305 stock car motor, which cost petitioner $7,500. In 2008 petitioner sold this car for $17,250. Also in 2004 petitioner purchased a new transporter to haul his drag racing cars to races and to use as an office and sleeping space when petitioner’s racing team competed away from home.

He had formed a drag racing team consisting of himself and his two children.  His drag racing “business” produced losses which he wanted to deduct.  The IRS did not agree and assessed him over $25,000 in additional tax for the years 2005, 2006 and 2007.  In order for losses from an activity to be deductible, it must be entered into with the intent of making a profit.  This can be a little fuzzy and the Court does a multi-factor analysis to make the determination.   Mr. Zenzen did not do that well:

At no time did petitioner have a written business plan for his drag racing, and he did not maintain a general ledger, annual budget and expense forecasts, or a separate bank account relating to his drag racing activity. Petitioner merely saved receipts reflecting his drag racing expenses. 

At no time before 2005 or during the years in issue did petitioner speak with abusiness adviser about ways to make a profit in drag racing.

The Court noted that Mr. Zenzen spent a lot of time on his drag racing activities and also sought advice on how to make his cars perform better but he never seemed to focus on making his business profitable.   Although there are other factors that seems to be the critical one.  Keeping good records is viewed favorably, but if you are keeping the records only to substantiate your deductions that is not enough.  You must be generating information that will help you make your business profitable.

Feng Shui as A Business Plan ?

Passing the test of your activity being for profit (Section 183) is the first of the several hoops you must jump through to post a significant negative number on the first page of your Form 1040.  I like Section 183 cases because they tend to make good stories.  It is not unusual for taxpayers to win these cases in Tax Court.  The most interesting taxpayer win in the last year or so has to be the case of Trieu M Le.  He and his wife were in the business of playingslot machines using the principles of Feng Shui.  The Court could not agree with the IRS that they were being irrational:

Petitioner is from a culture different from that generally extant in the United States, and he drew upon that culture to formulate his business plan. His plan was to use Feng Shui to determine which days were his or his wife’s “lucky days” and have that person bet heavily on those days.  He also used a technique of watching other players; and if they left a slot machine after heavy losses, petitioner believed that the machine was due for a payoff.

Not Just Horsing Around

There were also a couple of horse breeding cases won by the taxpayers.  It seems that horse breeding is the IRS poster child for hobby loss cases, but taxpayers seem to be able to win those cases.  The judges must feel as I do that there doesn’t seem to be that much fun in caring for animals that are considerably larger than you are.  They also seem to defecate quite a bit.  The winning taxpayers seem to be able to convince the Court that they don’t really like horses all that much, not ever riding them themselves and doing a cost benefit analysis before calling the vet.  Richard Frimi was one of the cases like that.

Tribute to Madeleine L’Engle

The taxpayer I really hated to see lose was Shawn Blanchette.  She had a science fiction memorabilia business, called A Wrinkle in Time, that she put a lot of energy into.  The Tax Court thought she was just having too much fun:

Ms. Blanchette is passionate about science fiction, and she derives great pleasure from her collectibles activity. This enjoyment, however, cannot overcome the complete disregard for profit objective with which she has conducted her activity. Given the small profit potential and significant satisfaction derived from the collectibles activity, we are confident that it is Ms. Blanchette’s quest for personal gratification that keeps her going and not any bona fide profit objective.

Somebody Somewhere Has To Be Buying Some Soap

There was also an Amway case.  Amway is a major corporation that sells a variety of household products.  Originally it was mainly soap.  Their story is that their stuff is more expensive, but since it is more concentrated you don’t have to use as much of it.  What they are better known for is their “multi-level” marketing system.  If an Amway distributor invites you to a party to discuss something, he will not try to sell you soap.  He will want to recruit you as a distributor.  He will focus not so much on you selling the soap (I’m using the term as a shorthand for the broad range of Amway household products).  He will focus on the opportunity you have to recruit other people who will become your “downline”.  At one step removed, they are also part of his downline.  In Amway terms, you are an “Independent Business Owner”.  Somewhere in the chain above you (“upline”) there will be someone who has achieved Diamond status, which is your ultimate goal.  Then you can just sit back and see how the money rolls in.

My short mention of the Amway case was picked up by another blog.  This revealed to me that there is actually a small section of the blogosphere dedicated to criticizing the Amway system.  My favorite is Married to An Ambot by a lady who is telling her story of what it is like to be married to an “Amway cult follower”.  I was inspired to do a comprehensive study of how Amway IBO’s have fared in “hobby loss” cases.  I found 23 cases going back as far as 1986 (There were some appeals, but I only counted the original case).  It’s not an enormous number but it is enough for a Tax Court judge to have observed:

The Amway distributorship system is well known to respondent (i.e. IRS)and this Court

A brief summary of what the critics have to say about Amway is that very few people make money at it.  Those that do may well exagerate their earnings to impress and motivate their “downline”.  The relationship between the upline and downline has elements of cult like behavior.  Most of the “soap” is bought by the IBO’s themselves.  Those in the upline who are making a lot of money are making most of it from selling “tools” (motivational tapes and the like) to the downline.  I don’t know whether this is all true or not, but the Amway hobby loss cases tend to support it.  They almost all lost.  Probably the most pervasive theme was that the IBO’s never seemed to try to control expenses and that they only sought advice from their upline, who were of course not going to give disinterested advice.  I was able to draw a pretty clear lesson from the material.

If you would like to start a small home business so that you can deduct a lot of money that you would spend anyway, don’t do it.  I didn’t need to study the cases to tell you that, of course.  The study of the cases tells me that if you are going to not follow that good advice and are going to start a business so you can deduct a lot of personal expenses, the last thing you want to pick is becoming an Amway IBO.

Conclusion

The most ironic thing to me about hobby loss cases is that the Tax Court ends up sounding like a good managing partner bringing some business discipline into a public accounting firm.  Most of us like the work and like our clients and staff and need somebody to remind us to keep money coming in the door.

Just for reference here are the factors:

(1) The manner in which the taxpayer carries on the activity;

(2) the expertise of the taxpayer in carrying on the activity;

(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 loss with respect to the activity;

(7) the amount of occasional profits, if any, which are earned by the taxpayer;

(8) the financial status of the taxpayer;

(9) elements of personal pleasure or recreation.

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