Jet service activity can’t claim losses
Jet service activity wasn’t for profit, so taxpayer can’t claim losses in excess of income
Hoffmann, TC Memo 2016-69
The Tax Court has concluded that a taxpayer was not entitled to deduct losses from his jet service activity that exceeded the amount of income derived therefrom because the activity was not conducted with the intent of generating a profit. The Court found that, contrary to the taxpayer’s argument that he was contractually “locked in” to a deal with the aircraft lessor and that he was merely trying to mitigate losses, he could have opted for the lessor to repurchase his interest in the aircraft when it become clear that there was no potential for profit.
Background. Code Sec. 162(a) allows as a deduction all “ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business.” To be deductible under this section, a taxpayer must show that he engaged in the activity with an actual and honest profit objective. (Hulter, (1988) 91 TC 371)
Under the hobby loss rule, deductions attributable to a “not for profit” activity are allowed only to the extent of income from it, or to the extent deductions are allowable regardless of any profit-seeking motive, whichever is larger. (Code Sec. 183, Reg. § 1.183-1 ) Reg. § 1.183-2(b) enumerates nine factors, discussed below in detail, to consider in determining whether a taxpayer has a profit objective. No one factor nor a majority of factors necessarily determines the outcome.
Facts. During the ’90s, David Hoffmann engaged in an executive search business through his wholly owned corporation, DHR International, Inc. (Original DHR). In ’98, Mr. Hoffmann pursued an opportunity to combine Original DHR’s business with many service businesses throughout the country in a new corporation, Enterprise Profit Solutions (EPS). Original DHR sold its assets to EPS on Dec. 14, ’98, and EPS started planning an initial public offering (IPO).
At the encouragement of the investment bankers planning the IPO, Mr. Hoffmann decided to acquire an interest in a Citation X aircraft, a long-range, medium-sized business jet, to profitably lease to EPS. He formed Hoffmann Holdings, LLC with his wife on Dec. 30, ’98, for that purpose. However, interests in Citation Xs were not immediately available, so Hoffmann Holdings initially leased interests in two other aircraft from NetJets Aviation, Inc. (NetJets). Hoffmann Holdings subsequently purchased from NetJets a 12.5% interest and a second 6.25% interest in two Citation X aircraft in ’99 and 2000. The purchase agreements contained a number of restrictions, including on transferability, and also had repurchase options. Hoffmann Holdings was also required to pay monthly management fees as well as various charges for the actual use of the aircraft. On the advice of a tax attorney, Hoffmann Holdings entered into a 3-year aircraft lease with Original DHR that was intended to demonstrate Hoffmann Holdings’ profit motive.
The EPS IPO fell through, and EPS ultimately sold its various businesses back to their original owners. On Feb. 6, 2001, Hoffmann Acquisition Corp. acquired Original DHR’s assets from EPS, then changed its name to DHR International, Inc. (New DHR). Mr. Hoffmann owned 75% of the New DHR stock. After New DHR acquired Original DHR’s assets, Hoffmann Holdings did not invoice New DHR for its use of Hoffmann Holdings’ aircraft and failed to formalize its arrangement with New DHR in a written lease.
In 2000, Mr. Hoffmann tried to unwind his deal with NetJets and have it repurchase Hoffmann Holdings’ interests in the two Citations aircraft, which NetJets was apparently willing to do despite the fact that the repurchase options had not become exercisable. However, Mr. Hoffmann decided to retain one of the aircraft (the retained aircraft) because Hoffmann Holdings had used the aircraft in excess of the hours allotted to it, and keeping the aircraft interest and “absorbing” the hours (i.e., by continuing to hold its interest) would be cheaper than paying for this excess use. (The over-flown hours would be fully absorbed by April 2002.) Hoffmann Holdings was dissolved in 2001, and Mr. Hoffmann succeeded to its interests in the aircraft. New DHR then used the retained aircraft for “certain business activity” during 2003 and 2004, although it had become clear in 2003 that, without EPS, Mr. Hoffmann couldn’t earn a profit from the business use of the aircraft.
On Nov. 18, 2004, Mr. Hoffmann traded his interest in the retained aircraft for a 6.25% interest in a Gulfstream 200 aircraft (the upgraded aircraft). However, NetJets repurchased the interest a short time later after Mr. Hoffmann claimed to have difficulties in scheduling flights. He mostly used the upgraded aircraft to fly to a vacation home.
From ’99 to 2002, the Hoffmanns reported Mr. Hoffmann’s jet service activity as generating a net loss each year, ranging from $110,839 to $356,406. In 2003 and 2004 (the years at issue), they claimed losses of $517,044 and $773,776, respectively. The increased losses were due to, among other things, substantially lower gross receipts.
IRS disallowed the deductions that the Hoffmanns claimed in respect to Mr. Hoffmann’s jet service activity in excess of the gross income reported from it.
Tax Court finds jet service activity wasn’t conducted for profit. The Tax Court, applying the factors in the regs, held that, despite Mr. Hoffmann’s stated intent, the objective factors indicated that Mr. Hoffmann didn’t engage in his jet service activity for profit during 2003 and 2004.
(1) Manner in which activity was carried on. Although Mr. Hoffmann initially carried out the jet service activity in a businesslike manner, he failed to do so during the years at issue. Specifically, Hoffmann Holdings didn’t invoice New DHR for its use of the aircraft or even have in effect a formal lease agreement. And Mr. Hoffmann’s claim that he was merely mitigating losses at that point, because he was “locked in” to the relationship with NetJets, was belied by the fact that he didn’t exercise the repurchase option (i.e., for NetJets to repurchase the retained aircraft) when the over-flown hours had been absorbed in 2002. And in any event, mitigating losses isn’t a profit motive.
(2) Expertise of taxpayer or his advisers. The Court found that, while Mr. Hoffmann claimed to have conducted studies and “gathered information from those experienced in the air transportation business,” this claim wasn’t supported by the evidence. None of his purported advisors offered advice on the jet service business—and, even if he did have advice when he started the activity, this wouldn’t show any profit motive during the years at issue.
(3) Time and effort expended. The record didn’t indicate how much time Mr. Hoffmann devoted to his jet service activity during the years at issue, and in any event, the Hoffmanns generally conceded that his focus at that time was to mitigate losses and not to make a profit.
(4) Expectation that assets may appreciate in value. Although Mr. Hoffmann claimed to have been advised that certain jet aircraft appreciate, this was insufficient to establish any reasonable expectation that partial interests in the particular aircraft he held—which were also subject to a number of transfer restrictions—would do the same. The Court also found that the terms of the repurchase option, coupled with the prior losses he had claimed, effectively precluded the possibility of making a profit through its exercise.
(5) Taxpayer’s success in carrying on other similar or dissimilar activities. The Court found that Mr. Hoffmann was successful in unrelated ventures, but that these ventures were dissimilar to his jet service activity and thus carried little weight.
(6) Taxpayer’s history of income or loss. Mr. Hoffmann never reported a profit from his jet service activity, either in the years at issue or those preceding them. He argued that the continuing and increasing losses during the years at issue were attributable to the failure of EPS’s IPO and his being contractually locked in with NetJets. However, the Court reiterated its finding that he could have ended that relationship back in 2002, and stated that the evidence indicated that his interest in the retained aircraft (and subsequent pricier trade-in) reflected more that he enjoyed the personal convenience of travelling by private jet, and perhaps anticipated getting a tax benefit from offsetting income with aircraft-related losses.
(7) The amount of occasional profits, if any, which are earned. Mr. Hoffmann never reported a profit from his jet service activity, and he even conceded that once EPS ceased being a customer—before the year at issue—there was no real opportunity to profitably charter the aircraft.
(8) Taxpayer’s financial status. The Court found that the Hoffmanns had substantial income from sources other than the jet service activity and that the losses they claimed from that activity reduced their taxable income. While the Court accepted that Mr. Hoffman’s “business savvy would most certainly not let him intentionally throw money away just because he may be able to recover a portion of it through tax deductions,” it found that the pleasure and convenience of travelling via private jet, in combination with a tax benefit, may have proven worthwhile.
(9) Taxpayer’s personal motives. Although Mr. Hoffman may have originally began the jet service activity with EPS’s IPO in mind, EPS was no longer around during the years at issue, and new DHR’s needs for jet travel services were insufficient to render the activity profitable. The Court found that Mr. Hoffmann continued the jet service activity during the years at issue for personal convenience.
Looking at all of the above factors, the Court easily concluded that Mr. Hoffmann didn’t carry on his jet service activity to make a profit during 2003 and 2004. Accordingly, the Hoffmanns were entitled to deductions attributable to that activity only to the extent allowed by Code Sec. 183(b).