Recently, the Tax Court ruled that an individual who received income as a nominee of a C corporation was not subject to the hobby loss rules of Sec. 183.
Facts: Jeff Potter worked for Green Country Soils Inc. as an independent contractor. In 1995, in his individual capacity, he entered into a compensation agreement with Green Country under which he was treated as an independent contractor and received a commission on sales to persons or entities whose account he served or had obtained. If either party terminated the agreement, Potter was entitled to 1½ times his commissions for the previous year.
In 1998, Potter formed a C corporation, Potter Sales Inc., as its sole shareholder, president, and employee. After the inception of Potter Sales, Green Country paid the commissions under Potter's compensation agreement with Green Country to Potter Sales, and Potter was paid a salary by Potter Sales.
In 2010, Green Country was bought by a competitor, thereby terminating the compensation agreement. Potter was paid $1,929,828, representing a termination payment of $1,729,828 plus $200,000 for a covenant not to compete.
Meanwhile, Potter began participating in an activity involving riding a horse and shooting targets. He received prize money from events and had various expenses related to the activity. The expenses for the activity were paid by Potter Sales, and although the checks for prizes that Potter won were made out to him, he deposited the checks into Potter Sales' bank account.
Potter and his wife's 2010 joint return reported the $1,729,828 termination payment as a sale of goodwill and the $200,000 noncompete payment as a capital gain. They attached Schedule C, Profit or Loss From Business (Sole Proprietorship), reporting the prize money he won in shooting events as business income with the offsetting expenses. The prize money in 2011 was recorded similarly. Potter discussed the treatment of the termination payment and the activity on several occasions with his CPA, who had worked for Potter for 35 years.
In 2013, the IRS issued notices of deficiency and penalties to the Potters and Potter Sales for 2010 and 2011.
Issues: The issues before the Tax Court were (1) whether the termination payment was for the sale of Potter's goodwill and whether it and the noncompete payment were capital gain or ordinary income; (2) if they were ordinary income, whether they were subject to self-employment tax; (3) whether Potter or Potter Sales entered into the shooting activity; and (4) if it was Potter's activity, whether it was entered into for profit or its deductions were limited by Sec. 183.
Holding: In determining that Potter did not sell goodwill, the Tax Court noted that he did not sell a trade or business or assets of one, which case law has held to be necessary for a sale of goodwill. Instead, the termination payment was for Potter's right to service Green Country's clients and to receive ordinary income. The court further held that the termination payment was subject to self-employment tax, reasoning that Potter was an independent contractor and the termination payment was tied to the commissions of the prior year.
In determining whether Potter entered into the shooting activity for profit, the court noted that the parties had stipulated that its claimed expenses were properly substantiated and that, if the court found it was entered into for profit, the deductions were properly claimed by Potter Sales. The Tax Court noted that nothing precluded Potter Sales from operating multiple trades or businesses. The court found that Potter received his prize winnings from the activity as Potter Sales' nominee and the activity was a trade or business of Potter Sales. Because Sec. 183 does not apply to C corporations, it did not apply to Potter Sales.
Lastly, the Tax Court denied an accuracy-related penalty because the Potters relied in good faith on the advice of a tax professional. The court found they met this requirement because the CPA who prepared their individual return and Potter Sales' corporate return had been the Potters' CPA for nearly 35 years and had always prepared Potter Sales' corporate returns; also, Potter discussed the items at issue with the CPA and gave him all the necessary information to prepare the returns.
- Potter, T.C. Memo. 2018-153
— By Maria M. Pirrone, CPA, LL.M., associate professor of taxation, St. John's University, Queens, N.Y.