Race Car Winnings

[newbie]

I say roll up your sleeves and see whether the 9 factors of hobby vs. business can be used to show that he has been behaving with a profit motive.

http://www.pleasurehorse.com/taxes/HOBBY_VS_BUSINESS.html

There are tons of articles on the hobby vs. business. This is a link to the 9 factors with some good guidelines to secure your clients position if you think a profit motive could be used.

[joanmcq]

case law could be in your favor

read John E. and Vicki D. Morrissey v. commissioner. he was a banker who raced for 13 years and had a profit only one of those years. He won his case; he did substantiate a profit motive and therefore his losses were deductible on Sch. C. Unfortunately, it cannot be treated as precedent, but the court's reasoning in finding in his favor is a good example of the 9 factors being used in the client's favor.

[AuditorTurnedGood]

If you want to bring a client to tears

do the taxes for a horse breeding operation. We had a pretty big horse industry here in the 70's and 80's (until they closed the track), and I did 2 audits with the state on people who were "breeding horses" in the 2000's. (I still don't know what to call this decade). One woman had put in over 400K over the course of 7 years into an operation that lost around 50K every year. She actually cried at the audit when we showed her this. I felt kinda bad nailing her with a massive tax bill.

We know the tax code is unfair from this side of the table. but there were days as an auditor I sincerely wanted to lose a case in the circular file. Some of the assessments just didn't feel right.

ATG

[Burke]

Try pointing out why he is having to pay taxes on $2800 when he has actually lost money. Then try to tell him he is allowed to deduct $2800 of his expenses but the deductions disappear into a black hole and only his revenue survives.

I understand where your client is coming from and can see his point. The same thing happens with gambling losses to a lot of people. All these activities, however, do not have anything to do with the TP's primary job or source of income most of the time. We all usually have hobbies of some sort for which we spend money, and this is what he likes to do. I don't have to agree with the tax code to put the best positive spin I can come up with to make it more palatable to the client. Again, if he does itemize, what happens?

[erchess]

Reactions

I surely do sympathize with the taxpayer on this one. He's not asking to deduct his hobby loss as if he were operating a profit seeking business that lost money and he gets an IRS Letter that wants to treat the prizes he won as revenue from a Sch C Business that had no expenses. (Of course all the IRS has is a 1099M and most of those go to businesses and the IRS couldn't possibly know what his expenses are so I don't mean to make them out as villains.)

Going forward perhaps the tax preparation community could ask for a change in the rules so that hobby income is reported on Sch C with a special box checked leading losses to be disallowed.

Meanwhile I have to agree with the suggestions from a couple of posters that since the IRS is asking for a Sch C it should be possible to give them one but I think I would show a zero bottom line.

[JON]

Menard

I think there is a court case that the Wisconsin Menards(rich) took all the way and lost. I never read the case, but more than one of the sons, including Paul-a Sprint car driver now, they lost and hired the best. I think it is tough especially when one of the drivers then was Paul who ultimately gets on a big time team.

[Snaggletooth]

Latest Attempt

Yep. This guy's expenses are sucked into a Schedule A that doesn't exceed the standard deduction. And the $2800 on Line 21 becomes entirely taxable.

By all standards of right and wrong (not that IRS really cares), my client should not have to pay on this phony income which is in reality a huge loss.

The latest attempt is to avoid reporting the $2800 on line 21. Notice that the amount to report is limited to gross profit such as what would be reported after deducting Cost of Goods Sold. Although normally limited to merchandising and related costs, the IRS is notorious for forcing the absorption of overhead costs into ending inventory to minimize Cost of Goods Sold. Taxpayers are not able to avoid classification of certain costs considered to be so "direct" that they must be inventoried.

My attempt to classify direct costs to COGS involves the following costs that are DIRECT.
1. Racing fuel some $1700. This stuff is much higher than what you pay at the pump.
2. Entry fees. 25 races @ $20 per race is $500.
3. Tires $600 per set, which lasts at most 1000 miles on dirt, $1450 total.

Already, this is enough to wipe out his $2800 winnings.

Indirect costs not directly associated: $4000 depreciation, interest on racer loan $3000, trailer-transport costs $800.

Of course, I'm going to ask the taxpayer for his numbers on the above, and hope he has receipts, but even without them there is substantial other proof.

Will this fly??

[erchess]

Personally

I think the IRS is expecting a Schedule C. I would give them one but I would claim only expenses he has receipts for and if necessary I would reduce that total so that he has a zero bottom line rather than a loss. Yes I think that will fly. I think if the person who you will write back to gets a C and a letter saying nothing substantive other than "here is the C. Sorry we left it off the return. Note the zero bottom line so the rest of the return does not change." then the recipient will write back tentatively closing the matter. In the mean while a clerical employee will type the C into the computer and you will hear back from someone else if the C is selected randomly or on the basis of diff score for examination. That's unlikely. If on the other hand you go with line 21 then you will have to write a letter explaining why you did not put the entire amount of the 1099 M there. This will not be routine and comfortable for the IRS recipient and he or she will scrutinize it carefully and perhaps invite peers and superiors to do likewise. You and your client need a comfortable IRS employee who can follow the routine not someone who must scrutinize.

Going forward I would do the same until the IRS writes the famous letter where they say they think he has a hobby but they will let bygones be bygones if his next return either treats racing as a hobby (for him no deductible expenses and therefore income but not SE tax on winnings) or shows a profit. I would respond to that letter based on the realities of his life and of our profession as they are at that time. Under the realities of his life as you describe them and the realities of our profession as I perceive them now I would respond to the letter by treating the activity as a hobby. I don't like that any better than you do but neither he nor you nor the IRS agent makes the rules and all three of you must follow them.

[Snaggletooth]

Direct Costs

Erchess, all of your reading was worthwhile, but you didn't answer the question. For example, you have healthy discussion about hobby vs. business treatment, but the client has already written to the IRS that this is a hobby, and IRS has responded with a letter stating the winnings should be put on Line 21 and expenses on Schedule A Miscellaneous.

What do you think of the classification of expenses into "direct" for Cost of Goods Sold, and "indirect" for 2% Sch A?

[DaveO]

I have a client, otherwise retired, who has around $1k of winnings from fishing tournements every year. I lump his entry fees into a "cost of goods" deduction to zero out the income and report it on an attachments. If it doesn't fit the letter of the law it certainly matches the spirit of it.

[erchess]

Snags

I think you can do as you suggest and eventually prevail.

I still think your client can change his mind regarding the hobby classification and get away with that and I still think that would be the easy way to wrap up the matter.

[JG EA]

...
The latest attempt is to avoid reporting the $2800 on line 21. Notice that the amount to report is limited to gross profit such as what would be reported after deducting Cost of Goods Sold. Although normally limited to merchandising and related costs, the IRS is notorious for forcing the absorption of overhead costs into ending inventory to minimize Cost of Goods Sold. Taxpayers are not able to avoid classification of certain costs considered to be so "direct" that they must be inventoried.

My attempt to classify direct costs to COGS involves the following costs that are DIRECT.
1. Racing fuel some $1700. This stuff is much higher than what you pay at the pump.
2. Entry fees. 25 races @ $20 per race is $500.
3. Tires $600 per set, which lasts at most 1000 miles on dirt, $1450 total.

Already, this is enough to wipe out his $2800 winnings.

Indirect costs not directly associated: $4000 depreciation, interest on racer loan $3000, trailer-transport costs $800.

Of course, I'm going to ask the taxpayer for his numbers on the above, and hope he has receipts, but even without them there is substantial other proof.

Will this fly??

I know I brought this up, but I just looked up definitions of cost of goods to see if this original thought would fly. For instance Materials that go into producing something are easily seen as COG, I also in some cases view paying other people to produce client's money as COG because I think the Gross income should reflect a lower amount to realistically represent the actual money coming into the cient, to be reduced further through operating expenses.

I now think you should look at COG's the same way as you would if on a schedule C. In other words Money In minus COG's = Gross Income. In your case to be put on Line 21.

Now on a Schedule C - if your guy was in business what would you take up the top before operating expenses? Probably all of the things you listed would be operating expenses? I would feel comfortable putting money spent to someone else to get the prize so maybe the fees would fly. But the gas and repairs? I now think that is operating expenses.

Whatever you decide - I'd put the prize money then a minus sign with those costs = Line 21 - if there is a 1099.

[AuditorTurnedGood]

at the end of the day

It's either income on 21 and expenses on A, or all on Schedule C. If we put it on 21 and A, we use expenses equal to income on 21. If we put it on C, we have to include all expenses of the activity, along with income, which we know ends in a loss. We can't take only "enough" expenses to get to 0, since that is, in fact, filing a knowlingly false tax return, because we can't file a "hobby Schedule C" . This is especially true if this guy/gal is in the EIC range; big no-no not to take all the expenses. As for the COGS argument, I think it would be hard to justify COGS = Income, plus there is no provision in the regs (that I'm aware of) that allows you to take any expenses in arriving at the Line 21 amount.

The end I see to this is sometimes, taxes suck.

ATG

[JG EA]

...As for the COGS argument, I think it would be hard to justify COGS = Income, plus there is no provision in the regs (that I'm aware of) that allows you to take any expenses in arriving at the Line 21 amount.

...

ATG

Regarding your quote see - TTB 5-20

Cost of goods sold deduction for hobby income. Gross income
for purposes of the hobby loss rules equals gross receipts minus
the cost of goods sold deduction. Any consistent method for determining
cost of goods sold is accepted as long as it follows generally
accepted methods of accounting. [Reg. §1.183-1(e)

[AuditorTurnedGood]

I stand

Regarding your quote see - TTB 5-20

humbly corrected.

ATG