What kind of deduction is a hobby expense?

In a case of first impression for the Eleventh Circuit, the court affirmed a Tax Court holding that expenses of activities not engaged in for profit, i.e., hobbies, are allowable only as miscellaneous itemized deductions under Sec. 67(a).

Facts: Carl and Leila Gregory created a corporation domiciled in the Cayman Islands, CLC Ventures Ltd. (CLC), in 2011. The purpose of the corporation was to own and charter a yacht. The Gregorys elected to treat CLC as a disregarded entity, reporting its income and expenses on their individual joint tax return. In the Tax Court and Eleventh Circuit, the Gregorys did not dispute that CLC’s activities were not “engaged in for profit within the meaning of [Sec.] 183.”

In tax years 2014 and 2015, the Gregorys reported CLC’s income and expenses on Schedule C, Profit or Loss From Business, of their Form 1040, U.S. Individual Income Tax Return. The IRS issued a notice of deficiency to the Gregorys for these tax years in 2018, recharacterizing CLC’s income as “Other Income” and its expenses as entries on Schedule A, Itemized Deductions. The IRS reclassified the majority of the expenses as miscellaneous itemized deductions subject to the floor of 2% of adjusted gross income (AGI) (Sec. 67(a)). This resulted in the Gregorys’ being unable to use nearly all the CLC expenses as deductions since their 2014 and 2015 taxable income was $19,666,293 and $80,154,735, respectively, and the CLC expenses did not exceed 2% of their AGI for either year. (For tax years beginning in 2018 through 2025, these miscellaneous itemized deductions are disallowed under Sec. 67(g).) As a result, the IRS assessed over $300,000 in deficiencies and penalties.

Issues: The key issue was the kind of deduction allowed for hobby expenses, since their amount was not in question. The Gregorys filed suit in the Tax Court to object to the deficiencies, taking the position that hobby expenses, as defined by Sec. 183(b)(2), are not miscellaneous itemized deductions under Sec. 67(a) subject to the 2%-of-AGI floor.

However, the Tax Court disagreed, upholding deficiencies totaling $267,221 for both years combined. The Gregorys did not contest the penalties (Gregory, T.C. Memo. 2021-115). They appealed their case to the Eleventh Circuit.

In their appeal, the Gregorys again argued that the CLC expenses should not be miscellaneous itemized deductions but instead be treated as above-the-line deductions under Sec. 183(b)(2). While Sec. 183(b)(2) permits “a deduction equal to the amount of deductions … allowable under this chapter … if such activity were engaged in for profit” (limited to gross income from the activity after other allowable deductions), the section does not specify where to take such a deduction.

The court noted that this silence on where to take the deduction is not uncommon in the Code and can be observed in the context of other sections such as Sec. 162, which defers to Sec. 62 for where taxpayers can deduct trade or business expenses. The root of the Gregorys’ appeal was the argument that “Section 183(b) (2) does not confer a specific deduction but a deduction framework.” This argument relies on the notion that if CLC were engaged in for profit as a business, Sec. 62(a) would permit the Gregorys to take trade or business deductions as above-the-line deductions.

The Gregorys argued that it should follow that Sec. 183(b)(2) would apply in the same way. The court underscored, however, that Sec. 183(b) (2) specifies only the “amount” of the hobby expense deduction rather than its “kind,” quoting dictionary definitions of both terms.

The Gregorys also noted that Sec. 183(b)(2) puts a maximum on the hobby expense deduction equal to the hobby’s gross income less deductions allowable under Sec. 183(b)(1). Their interpretation was that applying this rule should reduce a taxpayer’s gross income rather than AGI, making the hobby expense deductions above the line.

To consider this line of reasoning, the court delved into its distinction between the amount and kind of deduction Sec. 183(b)(2) allows. The text of Sec. 183(b)(2) specifies only the amount of deduction allowable for hobby expenses, meaning that other sections of the Code must be considered to determine the kind of deduction permitted (Hagans v. Commissioner of Social Security, 694 F.3d 287 (3d Cir. 2012); Cleary v. Waldman, 167 F.3d 801 (3d Cir. 1999)). The other applicable sections in this case were Secs. 62, 63, and 67, the court stated.

Sec. 62 lists all above-the-line deductions, and nothing implies that hobby expenses are missing from this exhaustive list, the court stated, so they are not above-the-line deductions. Sec. 63(d) defines itemized deductions as all deductions except (1) the above-the-line deductions listed in Sec. 62 and (2) any deduction referred to in Sec. 63(b). Sec. 183 is not mentioned in Sec. 63(b), so the court found that hobby expenses must be itemized deductions.

The Eleventh Circuit then noted that Sec. 67(b) defines “miscellaneous itemized deductions” as all itemized deductions other than 12 specific listed deductions, none mentioning hobby expenses or Sec. 183. Therefore, the court concluded Sec. 183(b)(2) expenses are miscellaneous deductions and deductible only to the extent that their aggregate exceeds 2% of AGI. The court explained that its reading was consistent with those of other courts (Purdey, 39 Fed. Cl. 413 (1997); Strode, T.C. Memo. 2015-117).

The Gregorys made five additional arguments, and the court saw no merit in any of them:

• The Eleventh Circuit previously has “recognized the connection between Section 183 deductions and the analogous adjustments under Section 162” in Brannen, 722 F.2d 695 (11th Cir. 1984);
• The court’s interpretation of Sec. 183(b)(2) “contravenes congressional intent”;
• Ambiguous tax statutes are to be construed against the government and in favor of the taxpayer (citing Royal Caribbean Cruises, Ltd., 108 F.3d 290, 294 (11th Cir. 1997));
• The court’s interpretation of Secs. 62, 63, and 67 “implicitly repeals Section 183(b)(2)” (citing Posadas v. National City Bank of New York, 296 U.S. 497 (1936)), so the court’s reading violated the canon against implied repeals; and
• The court’s “reading would lead to an odd or absurd result” (citing Pine v. City of West Palm Beach, 762 F.3d 1262, 1272 (11th Cir. 2014)).

Holding: Consistent with its interpretation of the Code, the Eleventh Circuit upheld the Tax Court’s calculation of the Gregorys’ tax liability. The question in this case largely pertains to statutory language. The court held that the Code “says … what it means and means … what it says” (quoting Connecticut National Bank v. Germain, 503 U.S. 249, 254 (1992)).

The court stated that “there is no general right to a deduction” because the “amount and type of deductions available to taxpayers ‘depend[] upon legislative grace’ ” (New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934)). The opinion also explained that, other than the small number of items Sec. 67(b) outlines as specific itemized deductions, all other itemized deductions are considered miscellaneous itemized deductions. Hobby expenses are thus included in those deductions subject to the 2% floor.

■ Gregory, No. 22-10707 (11th Cir. 5/30/23)

— John McKinley, CPA, CGMA, J.D., LL.M., and Thomas Godwin, CPA, CGMA, Ph.D., are both professors of the practice in accounting and taxation in the SC Johnson College of Business at Cornell University in Ithaca, N.Y. To comment on this column, contact Paul Bonner, the JofA’s tax editor.