This particular case was one mentioned by Tony Nitti in the over two hour BKD Simply Tax podcast with Damien Martin that was released on December 26, 2019[1] where Tony discussed his top 10 tax cases for 2019.  If you haven’t listened to this two hour discussion of cases, their importance in learning tax law, and how Tony deals with reading the number of cases he does, be sure to listen to the program.  You won’t be disappointed.

I had written on the topic, a case that involved a local attorney here in Phoenix, for Nichols Patrick in April of 2012 prior to the establishment of this website.  Because, as Tony notes, this is an especially useful case to understand hobby loss rules and we don’t have a lot going on at the end of the year, I’ve decided to publish this on the website here at year end.

The IRS decided that an attorney who was claiming deductions relating to a documentary she was filming was not engaged in the activity for a profit, and sought to disallow her losses.  Fortunately for the taxpayer, the Tax Court, in the case of Storey v. Commissioner, TC Memo 2012-115,[2] decided that in fact, her large losses did not indicate that she did not intend to eventually make a profit from the activity.

The case attracted the IRS’s interest for a number of reasons that often cause the IRS to question the profit motive of the taxpayer.  The taxpayer was a successful attorney in practice in Phoenix specializing in natural resource and water rights law.  Her income for the year in question from her law practice was in excess of $1 million.  Her husband had participated with Up With People as a teenager and Ms. Storey decided to film a documentary, titled “Smile ’Til It Hurts,” that outlined the history of that organization.

The taxpayer had incurred six straight years of losses from the activity.  The years before the court were 2006, 2007 and 2008 and, in fact, the taxpayer had received no income from the film and had received none until she received a $250 screening fee in March 2010 from a film festival.

Thus, the IRS theory was that the taxpayer was clearly “really” a lawyer and thus, in their view, wasn’t truly a filmmaker.  Rather the IRS believed she was pursuing the activity due to personal reasons related to her husband’s prior connection to the subject of her activity.  Her “true” business of being an attorney provided an income that was sufficient that, in the IRS’s view, she could pursue an expensive hobby that had no real hope of making money.

However, in this case there were other factors that lead the Court to find that Ms. Storey had a profit motive in pursuing the activity.  As is normal in such cases, the Court looked to the nine factors outlined in Reg. §1.183-2(b) to analyze whether a true profit motive existed:

• The manner in which the taxpayer carried 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 success of the taxpayer in carrying on other similar or dissimilar activities,

• The taxpayer's history of income or loss with respect to the activity,

• The amount of occasional profits, if any, which are earned,

• The financial status of the taxpayer, and

• Whether elements of personal pleasure or recreation are involved.

The taxpayer had conducted the activity in a businesslike manner.  She formed a business entity (a single member LLC) to operate the business, it maintained its own books handled by a bookkeeper Ms. Storey hired and regularly consulted with, she prepared a business plan, made changes to her production and plans over time based on information received, took steps to protect her reputation as a filmmaker and she marketed the film. 

The Court rejected the IRS view that the project was really conducted primarily as a “tribute” to the taxpayer’s husband, noting:

We specifically note our disagreement with respondent’s assertion that Smile ‘Til It Hurts was an exploration of William Storey’s youth, rather than an undertaking for profit. William Storey’s history in Up With People, which had been previously unknown to petitioner, certainly piqued her interest. His contacts and access to members of Up With People also facilitated her project. His appearance in the film is a small percentage of the total movie time, although compelling. His relationship to petitioner is not mentioned or otherwise noticeable in Smile ‘Til It Hurts. We find that Smile ‘Til It Hurts is not a tribute to or memoir about William Storey, as respondent argues. Instead, we find that petitioner’s efforts to make Smile ‘Til It Hurts a financial success show a profit objective and that this factor favors petitioner.

The taxpayer retained experts in the industry with which she consulted during her work, actions consistent with the actions a person looking to make a profitable film would take. 

The Court very specifically disagreed with the IRS’s assertion that because Ms. Storey was a successful partner in a law firm her film-making activity could not rise to the level of a full trade or business.  The Court noted that while she billed 30-35 hours a week on legal matters, she used other time to pursue the filmmaking, and specifically noted that a taxpayer may engage in more than one trade or business at a time.

The Court found the fourth factor (expectation that property will rise in value) not useful in this case, since it was essentially just looking at the overall issue—the film was the asset that might rise in value, but essentially it would do that if this was a profitable activity.  So the question was not one independent of Ms. Storey’s intention to operate a profitable venture.

The Court found that the taxpayer had been a successful attorney and had prior experience in the arts, producing musicals for a nonprofit organization from 1998 through 2003 and had received commissions for her bronze work.  These factors favored the taxpayer.

The Court found that the taxpayer was still in the expected “start-up” phase for a documentary filmmaker and thus it put little value on the fact that she had incurred substantial losses and had only insignificant income.  The film was not concluded until the end of the final year under examination and it could not produce significant income until that point in time.

The Court agreed with the IRS that the fact that Ms. Storey’s income from the law practice would allow her to pay for an expensive hobby and still maintain her expected lifestyle, finding that this factor favored the government—that is, Ms. Storey did not need this activity to generate a profit.  The Court also agreed that Ms. Storey clearly enjoyed filmmaking and, specifically, sharing the story of Up With People.   However, the Court did not find that these two factors meant that the operation could not have operated with a view towards making a profit.

Ultimately the Court concluded:

After considering all the facts and circumstances, we find that petitioner has shown that she engaged in her filmmaking activity for profit. We recognize some factors in this case that indicate the absence of a profit motive: petitioner has a history of losses, earns significant income from other sources and appears to enjoy filmmaking. These factors, however, are outweighed by the facts demonstrating that petitioner did engage in film production for profit. In addition to petitioner's testimony, which we found to be credible and forthright, the record shows an intent and effort by petitioner to engage in and continue in the filmmaking field with the purpose of producing income. We conclude that, during the years in issue, petitioner engaged in the filmmaking activity with the dominant objective and intent of realizing a profit.

The case was one that attracted the attention of the documentary filmmaking community, with the Court receiving amicus briefs from organizations related to such filmmaking in support of Ms. Storey. 

While the case was resolved in favor of the taxpayer, advisers should note that Ms. Storey, as an attorney, was probably more apt than many taxpayers in similar situations to maintain excellent documentation and books—that is, she had significant and well-documented independent evidence of actions that corroborated her assertion that the activity had been conducted for a profit.  The case may not have turned out so well had the taxpayer kept sloppy records or operated less formally.

[1] Simply Tax Episode 83: Top 10 Tax Cases of 2019 with Tony Nitti, December 26, 2019, https://www.bkd.com/podcast/2019/12/simply-tax-episode-83-top-10-tax-cases-2019-tony-nitti

[2] Storey v. Commissioner, TC Memo 2012-115, https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=10049