There’s nothing wrong with making money involving your personal passion or an enterprise that is “fun” for you. However, as evidenced by a new case, Zudak, TC Summary Opinion 2017-41, 6/19/17, you can’t claim a loss from a pleasurable activity unless you’re trying to turn a profit. Otherwise, the activity is treated like a “hobby,” so deductions are limited to the amount of income.
The taxpayer in the case, Mr. Zudak, was a fine arts major in college who dabbled in the theatre. But his main occupation was director of business development for a pharmaceuticals company, where he prospered. Eventually, his salary reached as high as high as $243,000 in 2013.
In 2012, Zudak managed a college film screening of a romantic comedy he helped produce. A few months later, he started College Film Festival (CCF)), a company devoted to organizing film festivals at colleges. But he did not draft a business plan, prepare profit projections or undertake a formal market analysis for CFF.
Subsequently, Zudak established a website for CFF. On this website, he posted a “LETTER from the FOUNDER” addressed to “Dear Filmmaker.” The letter explained that he hoped to “create a film festival where the interests of the festival directors would align with the interests and passions of working filmmakers, especially indie filmmakers."
The letter also stated: “[E]veryone knew I was serious about 1) artistic expression, 2) the indie spirit and 3) the value of aggressive creativity. They also knew I didn’t give a damn about generating revenue, catering to the donors or preserving an imaginary legacy. I just wanted to bring together academics, artists and business development folks, in a way that created value for everyone involved.”
CFF conducted a film festival at Penn State University (PSU) in 2013. PSU provided a theater free of charge for screening films and an unspecified number of hotel rooms for individuals who participated in the festival. Later in the year, Zudak had discussions with various individuals and corporate sponsors, aimed at obtaining financial, promotional and organizational support for CFF. But things never progressed any further.
On his 2013 return, Zudak reported gross receipts for CFF of $690 and expenses of $32,747, resulting in a net loss of $32,057.
Traditionally, the courts have relied on nine factors listed in the regulations – I call them the “notorious nine” -- to determine if an activity has been engaged in to turn a profit. They are:
- The manner in which the taxpayer carries on the activity;
- The expertise of the taxpayer or his or her advisers;
- The time and effort expended by the taxpayer in carrying on the activity;
- The expectation that the assets used in the activity may appreciate in value;
- The taxpayer’s success in carrying on other similar or dissimilar activities;
- The taxpayer’s history of income or losses with respect to the activity;
- The amount of occasional profits, if any, which are earned;
- The financial status of the taxpayer; and
- Any elements indicating personal pleasure or recreation.
No single factor is controlling. The determination is based on all the relevant facts and circumstances.
Unfortunately for Zudak, the Tax Court gave the thumbs down to his film festival business. He didn’t have a business plan, kept shoddy records and lacked practical experience in the film festival industry. Overall, he didn’t demonstrate a profit motive for the activity – in fact, the letter he posted on the website suggested the contrary. Therefore, the loss was denied.
If you have a client in a borderline situation, make sure he or she operates in a business-like fashion, especially when the activity is recreational or seemingly pleasurable in nature. The more of the notorious nine factors you can list on your side, the better.