Fishing charter activity not engaged in for profit

The Tax Court held that a taxpayer’s fishing charter activity was not engaged in for profit, after taking into account the nine factors of Regs. Sec. 1.183-2(b).

Facts: Donald Swanson, an avid fisherman for over 30 years, formed Happy Jack Charters in 2010 after retiring from two jobs. He acquired a boat with the intent of showing customers where and how to fish in Homer, Alaska, but otherwise had no formal business plan. The boat, a 22-foot Boulton Sea Skiff, was engineered to fish for halibut.

Swanson resided in Anchorage, Alaska, between 2014 and 2016 (the years at issue). Hoping to lower expenses, he arranged to store his boat, camper, truck, and other fishing supplies with his life partner’s children in Homer. Swanson eventually bought a plane to shorten his travel time from Anchorage to Homer. He also wanted to transport customers but could not because he maintained only a student pilot license. Eventually, Swanson hoped to retire, buy a cabin in Homer, and spend his time fishing.

The halibut season in Alaska runs from May to September. Alaska requires commercial fishermen to have a permit to fish for halibut. It further requires all commercial fishermen to keep a detailed daily log of any fish caught and file these logs with the Alaska Department of Fish and Game. In 2014, Swanson did not obtain the requisite permit and thus filed no logs; in 2015 and 2016, however, he rented a permit and filed daily logs. He reported fewer than a dozen fishing charter trips for those two years and also made some personal use of the boat. Swanson suffered a knee injury in 2015, but it did not impair his ability to work as a boat captain. A fire in 2016 required repairs to the boat that removed it from service for one or two weeks.

Swanson did not live off his income from Happy Jack Charters; his main sources of income were Social Security, pension, and rental income. He did not maintain a separate bank account, accounting records, or income and expense reports for the fishing charter activity. The only records he kept were “expense receipts,” which he gave to his accountant at year end to help in preparing his tax return.

During a 2014 audit of Swanson’s 2010 federal income tax return, an IRS agent told Swanson that he did not have the “right kind of insurance” or “right kind of license” for Happy Jack. Swanson allegedly corrected these issues after the audit. He also joined the Chamber of Commerce and began using Square, a point-of-sale application for small businesses.

Swanson traveled to trade shows with a desire to solicit new customers for Happy Jack Charters during 2014 through 2016. Although he gained no new customers from trade show advertising for those years, the advertising did attract at least one new customer in 2017.

For tax years 2010 and 2012–2016, Swanson reported $131,105 in net business losses, of which $57,030 occurred during the years at issue. The IRS conducted a bank deposits analysis, concluding that Swanson had unreported income of $80,549 for the years at issue. Following the audit, the IRS issued a deficiency notice asserting that Swanson’s charter activity was not engaged in for profit under Sec. 183 and, therefore, he was not entitled to business expense deductions.

Issues: In general, taxpayers are allowed deductions for business and investment expenses (see Secs. 162 and 212). Individuals are not allowed a business or investment expense deduction if the activity is not engaged in for profit (Sec. 183(a)). Sec. 183(b), however, allows deductions that would have been allowable if the activity had been engaged in for profit, but only to the extent of the activity’s gross income.

An activity not engaged in for profit is defined as “any activity other than one with respect to which deductions are allowable” under Secs. 162 and 212 (Sec. 183(c)). For an expense to be fully deductible under Secs. 162 and 212, the taxpayer must show that making a profit is the primary objective for engaging in the activity (Wolf, 4 F.3d 709 (9th Cir. 1993), aff’g T.C. Memo. 1991-212). Even though the profit expectation need not be reasonable, there must be an “actual and honest objective” of making one, reflected in the taxpayer’s conduct (Keating, 544 F.3d 900 (8th Cir. 2008), aff’g T.C. Memo. 2007-309). More weight is placed on objective facts than on a taxpayer’s self-serving statement of intent (King, 116 T.C. 198 (2001)).

Regs. Sec. 1.183-2(b) supplies a nonexhaustive list of nine factors to be considered in determining whether an activity is engaged in for profit:

1. The manner in which the taxpayer carries on the activity;
2. The expertise of the taxpayer or the taxpayer’s advisers;
3. The taxpayer’s time and effort spent 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, that are earned;
8. The taxpayer’s financial status; and
9. Whether elements of personal pleasure or recreation are involved.

No one factor or multitude of factors controls; all the facts and circumstances surrounding the activity should be evaluated (Golanty, 72 T.C. 411 (1979)).

A taxpayer may carry on an activity in a businesslike manner by maintaining complete and accurate books and records and by conducting the activity in a manner consistent with other like activities that are profitable. This includes “a change of operating methods, adoption of new techniques, or abandonment of unprofitable methods” with the goal of improving profitability (Regs. Sec. 1.183-2(b)(1)). Under Sec. 183, an important question is whether the taxpayer uses the records kept to increase profitability through effective accounting controls (Golanty, 72 T.C. at 430).

The court found after conducting a trial that Swanson failed to conduct his fishing charter activity in a businesslike manner because he did not develop a business plan, open a separate business bank account, or establish controls to help improve profitability. Also, Happy Jack Charters suffered relatively significant losses for its entire existence.

Swanson cited as evidence of a profit motive his efforts to keep expense receipts for his accountant, advertise the activity, and change the activity’s operations in response to the IRS agent’s comments in 2014 during the audit of his 2010 return. Taken together, however, the court found this was insufficient to show the fishing charter activity was conducted in a businesslike manner. The court found that the changes Swanson made after the audit were merely to satisfy regulatory requirements rather than to help manage profitability. Furthermore, Swanson made no other changes that increased his likelihood of making a profit.

While recognizing Swanson’s knowledge of fishing, the court found that he failed to exhibit adequate expertise in running a business or to show that he consulted with proper experts. Even after joining the Chamber of Commerce, Swanson could not demonstrate that he was better equipped to run a business, much less a fishing charter business. Only after the IRS audit did he obtain the appropriate fishing license and insurance.

The lack of fishing charter trips taken during the years at issue supported a finding that Swanson had failed to devote much personal time and effort to carrying on the activity, the court found. Furthermore, Swanson offered no evidence that Happy Jack Charters’ assets were appreciating in value or that he had success in carrying out similar or dissimilar activities. The only other activity in which he was involved was management of two rental properties, both of which generated losses in the years at issue.

An activity is not classified as a hobby simply because it involves personal or recreational aspects (Jackson, 59 T.C. 312 (1972); Regs. Sec. 1.183-2(b)(9)). However, “where the possibility for profit is small … and the possibility for gratification is substantial, it is clear that the latter possibility constitutes the primary motivation for the activity” (quoting Burger, T.C. Memo. 1985-523). Swanson’s use of the boat for personal fishing trips and his retirement plan to fish in Homer suggested he enjoyed fishing very much. In addition, he was unable to reconcile the number of times he refueled the boat on days with no fishing charter customers.

Holding: Evaluating the relevant factors enumerated in Regs. Sec. 1.183-2(b), the court held that all factors except for No. 4 (i.e., an expectation of asset appreciation, which was deemed neutral) weighed against Swanson’s fishing charter activity being engaged in for profit. As a result, the activity’s expenses could be deducted only to the extent of its gross income under Sec. 183. The court also held that the IRS’s determinations based on its bank deposits analysis with respect to unreported income were appropriate.

■ Swanson, T.C. Memo. 2023-81

— Luke Richardson is an associate professor of instruction and Kerkering Barberio fellow in accounting and taxation in the Muma College of Business at the University of South Florida; Isaac Chasen is a recent graduate of the SC Johnson College of Business at Cornell University; and John McKinley is a professor of the practice in accounting and taxation in the SC Johnson College of Business at Cornell University. To comment on this column, contact Paul Bonner, the JofA’s tax editor.