20 QUESTIONS EVERY CHARTER OWNER SHOULD ASK – BEFORE THE IRS DOES
Why YES Is The Answer To Preventing IRS Scrutiny & The Reclassification Of Your Business As A Hobby
In the Inflation Reduction Act, Congress allocated $80 billion so the IRS can hire 87,000 new agents with the goal to increase enforcement actions and audits specifically targeting certain taxpayers in order to secure greater tax code compliance, catch tax cheaters, increase tax revenues, reduce the “tax gap” and ensure “they pay their fair share.”
Of course "they" is just political speak which means "you".
Not surprisingly, many such targeted taxpayers and their families undertake various economic activities in which they are familiar – yacht charter, jet charter, horse breeding, etc. – as businesses; thereby taking full advantage of all allowable business tax deductions.
"Invest in what you know." Peter Lynch
However the IRS is incentivized to reclassify economic activities as hobbies and not businesses.
While all hobby income is fully reportable and taxable in the year earned – unlike with a business - taxpayers cannot currently deduct any expenses associated with a hobby.
This includes any and all possible asset depreciation expense: MACRS, Section 179 and any bonus depreciation.
Can you imagine how much in new taxes and penalties the IRS can collect if it successfully reclassifies unprofitable yacht charters, jet charters, horse breeders etc., or those that are occasionally only minimally profitable, as hobbies and not businesses thereby denying all deductions and expenses?
TAX CHEAT OR BAD BUSINESS, WHAT CAN YOU PROVE?
If your economic activities have not earned a significant net after tax profit 3 out of the last 5 years or 2 out of 7 for horse breeding, then the IRS presumes your economic activity is a hobby and not a legitimate business thereby prohibiting any and all business deductions but still requiring taxes paid on all the hobby income.
The burden of proving your unprofitable - or only marginally or sporadically profitable economic activity is a legitimate business with the primary purpose being a profit motive falls upon you - the taxpayer.
Can you prove your primary purpose for conducting the activity in question is to earn a significant after-tax profit as opposed to having the taxpayers subsidize your luxury leisure lifestyle?
Can you prove it to a skeptical IRS and Tax Court looking for increased income from perceived wealthy tax cheats?
The IRS recognizes it’s not uncommon for business profits to fluctuate, especially in the beginning. Tax Courts have established general guidelines to help determine when a taxpayer has a primary profit motive or some other primary motive such as minimizing operational expenses or personal enjoyment.
Nevertheless, a half baked plan with limited effort to only generate some income, defraying expenditures, or mitigating expenses in order to offset the costs and make a luxury lifestyle more affordable - is not a profit motive.
Thus, the ultimate determination between a hobby or a business is by the taxpayer’s actual primary motive – earning a profit or something else - which is dependent upon each individual taxpayer’s unique facts and circumstances.
THE SOLUTION IS SIMPLE - CONSISTENTLY EARN A NET PROFIT
So while it’s possible a taxpayer can have a primary profit motive from activities that are consistently unprofitable, obviously best way to prove a primary profit motive is to consistently earn a significant net after tax profit.
YES believes profitable, cash flow positive activities are often significantly more rewarding in other ways as well.
However, if you have not, or elect not to make any changes to earn a net profit from your potentially suspect economic activities, here are some questions to get you started thinking about your defense of your hobby / business activities.
20 QUESTIONS EVERY CHARTER BUSINESS OWNER SHOULD ASK – BEFORE THE IRS DOES-
1. Have your activities earned a significant net after tax profit 3 out of the last 5 years (2 out of 7 for horse breeding)?
2. If not, why not?
3. Do you conduct these unprofitable activities in the same manner, care and diligence as your profitable activities?
4. If not, why not?
5. Does your activity have a competitive advantage? If so, what is it?
6. Do you regularly make changes to your business plan? Your marketing plans? Your management team?
7. Do you regularly conduct SWOT analyses?
8. What if any changes are you planning to enhance current and future profitability?
9. Has your financial situation changed since you have been conducting your activities?
10. Is the present value of your net profits “substantially greater” than the present value of any and all tax benefits?
11. Are you in full compliance with all of the applicable tax code requirements?
12. Are you ignoring some of the regulations or trying to get by only with “half measures” or partial compliance?
13. Are you current and up to speed with all applicable tax law changes, new regulations and tax court interpretations? How would you know?
14. Does your current advisor / manager / broker act as a fiduciary by putting your interests ahead of his or do you believe he cares more for his business than yours?
15. Who is making more net after tax profit from your activities– you or your advisors, managers, and brokers?
16. Prior to buying the activity assets: boat, plane, horse, etc., and up until the present - have you consulted with and relied upon the advice of any outside professionals that are not affiliated with, work for, or are otherwise connected with, or have any joint or vested interest with the company that sold you the asset or that is currently managing it?
17. Do you have any independent business advisers for your activities?
18. As an effort to make your activities more profitable, does your current management team welcome participation, ideas, suggestions, and oversight from other unaffiliated business professionals that might make your activities more profitable – or are they overly controlling, reluctant, defensive, appear threatened, and act as if they possibly have something to hide?
19. Did you buy an asset; boat, plane, horse and then place it in a management program with the same company or an affiliate of the company that sold you the asset?(AKA “Boat as a Business” where possible tax benefits are presented by yacht brokers and charter management companies as the primary means of mitigating the expenses of buying and operating a boat for personal pleasure by participating in a comprehensive, all inclusive, one size fits all charter business model with an “approved template” that is supposedly sufficiently compliant for any and all unique and specific facts and circumstances of any boat owner.)
20. Do your current team of advisors know how to make your activities profitable? Why haven’t they told you already? Or why haven’t you implemented their advice?
That if your current advisors knew, surely they'd have told you already- wouldn't they?