Searchlight, Nevada

When unhappy with his press release, Ralph rewrote it and sent changes to Northwest. When dissatisfied with Northwest’s marketing, he wrote demanding that they comply with the terms of their agreement.

By letter dated January 22, 1996, Northwest’s account executive told Ralph that 6,800 copies of Searchlight, Nevada had been ordered and shipped. It didn’t say who placed the orders or where they shipped them, but said that another 2,500 copies had been ordered by the chain Books A Million. Northwest promised royalty statements in about three weeks.

On his 1996 Form 1040, Ralph reported $2,600 in gross royalties from his writing activity.

In late 1993, after signing with Northwest for Searchlight, Nevada, Ralph began researching Nevada Nights, San Joaquin Dawn. He wanted to document the difficulties that women face when attempting a break from prostitution. “The story’s never been done before to any degree of authenticity,” he said, explaining that he thought it was commercially viable.

Ralph, however, had learned that rooms at brothels were equipped with listening devices. Therefore he met prostitutes at other locations on “out calls,” paying by credit card. In 1994, during January, February, April, May, June, and July, he spent from one to six days a month in Nevada on “out calls.” He successfully encouraged ten prostitutes to leave their profession. As of his trial, he hadn’t finished Nevada Nights, San Joaquin Dawn.

Some time after signing with Northwest on Searchlight, Nevada, Ralph submitted the 450-page Lightning at Dawn. He thought that Northwest only required a joint venture payment for first novels, and so if Northwest agreed to publish Lightning at Dawn, he’d not have to pay anything. He also tried marketing Boys and Girls Together, but stopped when he was told that there was no need or market for that type of short stories at the time.

Silly Sarah

Consider Sarah Lesher, who had had a couple of appalling encounters with the IRS, partly because she didn’t adequately prepare.


From 1976 to 1980, Sarah worked for Yale as a research associate and computer programmer. When she learned of a publisher of travel guides in need of information for a revised edition of an African travel guide, she contacted the publisher and received information regarding the submission of articles.

Sarah traveled to Africa in October 1980 and then to Israel in January 1981. While in Israel, apparently to gather information for writing, the Weizmann Institute employed her as a computer programmer. During 1981 she bought a typewriter and wrote at least one draft of a fictional work based on her adventures while in Africa and Israel. She didn’t keep any type of business accounting records of her writing activities. Nope, Sarah thought she could get by without debits or credits or other financial or non-financial records.

My friend Doug, longing to deduct the costs of going to Vietnam to get photographs of unique motorcycle use to create a picture book, might want to pay attention to this case as an example of what not to do.

In September 1981, Sarah left Israel for Europe and then returned to the United States at the end of November. During 1981 she incurred a total of $9,847.13 in expenses connected with her travels. She deducted this amount on Schedule C of her 1981 Federal income tax return.

Again in 1982, Sarah traveled to Africa, possibly for writing materials, and there resumed working as a computer programmer. In April 1983, she returned to the United States where she continued her education and again worked as a computer programmer.

Sarah lacked experience writing any type of literary work prior to her trip. Further, she didn’t publish or sell anything she wrote with respect to her travels before her Tax Court trial. By then she still hadn’t engaged a literary agent to help her to publish. (It doesn’t appear that the Tax Court knows how difficult it is to get a literary agent.)

Silly Sarah didn’t ever show the court that she had traveled to Africa, Israel, and Europe to write, or that she had remained in Israel in 1981 to author works that could make money. The court said that Sarah used her fiction manuscript as a pretext to claim her travel as a tax deduction. Essentially, the court said that Sarah’s fiction was a fiction.

While Sarah introduced several hundred exhibits, including a copy of a draft of her novel—it makes one wonder how that impacted her copyright—correspondence and information concerning the accomplishments of her ancestors, friends, and acquaintances, her personal life, her activities for many years before and after the years in issue, and even the backgrounds of various authors, the court still said that Sarah used her draft novel as window-dressing to support claims for travel expense deductions.

“Preparation precedes power.” Remember that axiom. Prepare to be a better artisan and to address every IRS concern by studying your expression activity’s accepted business, economic, and scientific practices, or by consulting its experts.

Integrate Financial and Non-financial Records into Your Dynamic Business Plan

Sloppy books and jumbled records can point to a hobby. In one case the Tax Court said, “The record . . . is vague and confusing. There is no clear picture of the exact nature of [the taxpayer]'s recording activities. Nor is there a clear picture of how and when, if ever, these activities are going to result in a profit.” The court goes on to say:

…the record was incomplete, without evidence of an organized, businesslike attempt by [the taxpayer] to engage in an activity for profit. [He] did not introduce evidence of long-range planning or of organized recordkeeping. Nor did he introduce evidence to prove that he had regular customers and receipts— normal attributes of a profit-making enterprise.

Moreover, in many instances the evidence which appears in the record tends to indicate that [the taxpayer]'s activities were motivated by pleasure rather than by a desire to make a profit. At no time through the end of the taxable year in question did [taxpayer] hold himself out to the general public as being engaged in business. Indeed, [the taxpayer] did not even carry on his recording activities during the year in question.

So be certain that your records—financial and non-financial—present a clear picture and the exact nature of your expression activity. Integrate financial and non-financial records into your dynamic business plan.

Plan, Pursue the Plan, Adapt

The Court in Stasewich's new case (Richard A. Stasewich v. Commissioner, T.C. Memo.2001-30. The earlier case was Stasewich v. Commissioner, T.C. Memo.1996-302.) said:


"[Richie] has not made any significant changes in the operation of his artist activity, during the years in issue here, that would create a market or allow him to benefit from a market for his artwork or allow him to make up for his substantial losses. In [his earlier case before this court], we explained [that] ‘The large unabated expenditures, the absence even at this late date of any concrete business plans to reverse the losses, and the manner in which [Richie] conducted his artist activity lead to the conclusion that this was not an activity engaged in for profit."

Make a business plan and make it live. Your new business should change and develop just as a new baby grows and matures.

Richard Stasewich (I’ll call him Richie) of Chicago attended Northern Illinois University between 1971 and 1977, majoring in art and minoring in accounting. Richie didn’t graduate. By 1978 he was registered as a CPA and by 1983 Illinois had licensed him as a public accountant. Between 1978 and 1984 Richie worked in various positions utilizing his accounting background.

From 1992 to 1995 Richie operated both his accounting and artistic activities out of the building where he worked and lived. Beginning in 1984, he treated his artist and accounting activities as sole proprietorships for Federal income tax purposes. He reported net profits and losses for his two separate Schedule C activities as follows:

Richie’s income from artist activities without expenses for 1992 to 1995 was only $770, $320, $266, and $357, respectively. Needless to say, he didn’t support himself from this expression activity, and his accounting-activity income came in handy for his sustenance. Not only did he support himself with such work, but he kept good financial records and was able to show the IRS substantiation for all of the expenses he claimed on his returns.

Richie had a Certificate of Registration from Illinois that permitted him to engage in business, selling tangible personal property at retail. He filed state sales and use tax returns and completed Forms W-2 for the art students he employed.

What Richie didn’t keep were records of a budget or financial projections for his artist activity, or records of costs he might incur in attempting to develop his artist activity. That is, he didn’t plan well.

At trial Richie explained that before 1992 he had decided to create a commercially viable product from nude drawings. He tried fashion illustrations and spent a lot of money on materials and props, but never secured a large client and never earned anything from it. Around 1992, his artist activities changed from nude drawings and fashion illustrations to portraitures and installation art displays. For $1,200, he placed two advertisements in his local newspaper to solicit work as a commissioned artist of portraits. He painted two portraitures between 1992 and 1995 that generated about $850 in revenue. From 1992 to 1995 he created four displays of installation art consisting of peppers, dolls, pumpkins, and cucumbers. These he displayed in front of his residence. The exhibition of dolls received media attention, was the subject of two newspaper articles in 1994, and was mentioned in another newspaper article in 1995. (I guess journalists passed on reporting about the exhibitions of peppers, pumpkins, and cucumbers.)

Richie's income from the installation displays totaled a measly $88.04 . . . of donations.

The IRS audited Richie first for 1988-1991. The dispute ended up in the Tax Court, where he lost. This didn’t deter Richie from claiming his expression activity losses from 1992-1995 and again taking the matter to court. We'll talk more about this in the next posting, too.

Formulate a Plan

After I retired from a long, long career with the IRS. I wanted a change of pace. I still wanted to utilize skills and experience garnered over the thirty-four years I worked for the IRS as an Appeals Officer. Yet I wanted to go in a new direction, and make money doing it!


Like you, I’d dreamed of making my expression activities profitable. I had a long almost-written novel under my belt that my critiquing group seemed to like..My short stories had won a writing competition or two. I’d had some things published in the newspaper. Up until then, though, I'd been dabbling, puttering around, dreaming big—like most of you. Writing had been my hobby. Okay, how did I transform it into a business?

I can imagine you shouting at me: “Walt, after working that long for the federal government, especially for the IRS, your judgment and work ethic must be shot. Surely you can’t be serious about making money by writing. I advise you to buy a lottery ticket, sit back and relax with a cold drink, and forget writing to make a profit. It’s a pipe dream.”

Perhaps you’re right . . . about the lottery ticket. By now you should know I believe in true grit. So let’s move on.

First, I made my plan. Mine started as follows:


Summary

“Make expression less taxing” was my mission statement . . . at first. It changed as my business progressed. At the time it gave clarity to my plan while leaving room for imagination. Eventually I planned it would become “Make expression very profitable.”

This was a start-up. I’d begin when I retired from the IRS. I’d write books and articles to self-publish and them market myself, or sell them through conventional methods—utilizing agents, editors, publishers, etc. I’d participate in local writing societies and critiquing groups, hoping to gain feedback from those who read and write in order to hone my craft.

I’d write from home or wherever I happen to be in the course of my expression activity or my personal life. My business would entail travel and entertainment.

My primary marketing tool to begin with was to be a self-help book about making expression activities less taxing, thus paying less to the IRS and related state and local income tax authorities. I’d speak publicly. The value of my presentation would command the cost of travel and a speaker’s fee. I’d utilize speaking engagements and the sponsoring platforms to market my books.

I'd also do professional representations of taxpayers engaged in expression activities who have problems with the IRS.

Since my retirement pension would be less than my salary was when employed, my goal would be to profit from this new business sufficiently to make up the difference. After that I’d aim to net an amount equal to my pre-retirement wages. Subsequently, I’d steadily increase revenues, hoping eventually to make a generous income and gain a solid reputation that could command respect and attention in the publishing world.

Initial sources of revenue would be the sale of my book, Making Expression Less Taxing, and fees for speaking on the relationship of expression activities and taxation. I’d augment this revenue by representing clients with federal tax problems relevant to expression activities with the IRS.

I suggest you start formulating your own business plan like I did.

Planning to Exploit the Graces

John (see Ellsworth v. Commissioner, 21 T.C.M. 145, 150-51 (1962)) was 65 years old and had a plan. The attendant facts showed it’d take him 15 years to generate a profit. Yet the Tax Court said that a trade or business existed in his case because his purpose in “carrying on the activity” was to profit.


America was founded to avoid high taxation, right? Today avoiding high income taxes takes planning to exploit all of the graces. So it should be no surprise that you need to plan relative to your own expression activity. Remember, experience isn’t necessarily a requirement for having a trade or business. But a good plan is. So to answer further the question, “Is my expression activity a trade or business?” let’s look at the process of planning next.

Is My Expression Activity a Trade or Business?

Guess what? Federal income tax law and related regulations don’t define what “trade or business” means. Surprised? You shouldn’t be. I told you there was plenty of mystery in taxation. Ambiguity, it seems, is intentional. Some wit compared an income tax return to a girdle. You put the wrong figure in it and you can get pinched.


Tests to check if a trade or business exists stem mostly from court opinions (primarily from the United States Tax Court or from appeals made from those decisions ). Courts have developed two key definitional elements, one for “profit motive” and the other relating to the “scope” of the activities.

Finding out the motive is a key element in figuring out a mystery, right? A trade or business doesn’t exist unless a taxpayer “enters into and carries on” an activity with a good faith intention to make a profit or in the belief that a profit can be made from the activity. Money is the motive—bottom-line profit. That means you have cash left after all expenses are paid. Faith that an activity will generate a profit doesn’t need to be reasonable. However, simply hoping and wishing it will be profitable absent specific plans suggests that you lack good faith.

Remember the cold-fusion fiasco? The notion that oodles of cheap atomic energy could be produced cheaply and “coldly”? Too good to be true, right? Well, one Burnet Outten, Jr.—I’ll call him Bernie—representing himself without an attorney, took his tax controversy concerning cold fusion and graces relative to it to the U.S. Tax Court in 1984.

Bernie seemed a bit “unusual.”

He didn’t file federal tax returns from 1972 to 1979, for one thing. He had an interest in Western Metal Products Company (Western), a manufacturing concern. Besides manufacturing, according to Bernie, Western conducted atomic energy research. Yet Bernie was the only company participant in such research. Ostensibly, an experiment in 1951 resulted in nuclear fusion. Bernie, however, didn’t “realize” that nuclear fusion had occurred in 1951 until 1961, while doing further research. Bernie purported that Western repeated the 1951 experiment in 1971. Neither Bernie nor Western ever patented any such process.

Bernie believed that the world was created by cold fusion. He seized upon the alleged religious significance of the creation of the world by such process. His legal briefs contained extensive arguments about scientific experimentation and religious freedom. They explored history from Thomas Jefferson to Ronald Reagan and from the Bible to reports of the Atomic Energy Commission.

Over the years Bernie often attempted to inform scientists and government officials of his miraculous “discovery,” asserting that it was never duplicated. Some commentators expressed polite interest; others found it . . . well, a joke.

Neither Bernie nor Western received any filthy lucre, let alone profit, from said nuclear fusion “process.” No income relative to it was reported. Western’s income, if any, came only from manufacturing. Nonetheless, by 1978 Western established a $50,000,000 book value for this fusion “process.” On 1977 through 1979 tax returns, Western listed net operating losses of $100,000, $10,000,000, and $5,000,000, respectively. The preparer of the return described these losses as a “write-off of capitalized research work.” Bernie concluded that a grace was justified because government officials ignored him and his “discovery.” It was strange. Sort of like the President of the United States releasing his tax returns which listed the economy as a liability and write-off.

During the audit Bernie listed various actual expenditures—small amounts—that he made during the years involved. He gave the list to IRS. These included mostly expenses for his home office and for his move. IRS attorneys acknowledged that the expenditures were made by Bernie, but scoffed at them falling within any acceptable grace. The Tax Court concurred, saying that Western faced “a multitude of obstacles.” The court focused on just one: profit motive. It said that no income was generated nor was any likely to ever be generated from the fusion activity.

Well, let’s face it. Bernie’s circumstances were “singular.” His mistakes cost him more taxes. He was like a conservative president deducting right-to-lifers as dependency exemptions, accepting his election as a gift, and trying to write off the losses in Iraq. Nonetheless, something can be learned from Bernie’s case. As a man of religion once said, “If you make a mistake, all is not lost. You can always be used as a bad example.” So let’s use Bernie’s case as a bad example. It can teach us what not to do. I’ll summarize some points below and expand upon them in chapters to follow.

First and foremost, figure out how to make money from your expression activity. Have a profit. Bernie didn’t make any money from cold fusion. Make a written plan setting forth how you plan to make a profit from your expression activity. Follow it. If it doesn’t make money, change your plan so you think it will after the change. Keep following the plan and revamping until you make money or decide you can’t make money. If it comes to that, your expression activity becomes increasingly difficult to sell as a trade or business. Eventually, it becomes almost impossible to convince the cynics at IRS.

Second, keep complete and accurate records, both of a financial nature (you know, dollars and cents, checkbooks, receipts, debits and credits, etc.) and non-financial records (like submission databases, contracts, business plans, correspondence with agents, diaries or journals, etc.). From the opinion of the Tax Court in Outten v. Commissioner, it doesn’t appear that Bernie kept very good records of his activities, does it?

Make certain that your expression activity has substance. Don’t be naïve like Bernie was by boasting it hadn’t been duplicated when duplication was the very thing that may have given it some scientific credence. Know the ins and outs of your activity and know how to communicate them.

Another thing; don’t try to hide your expression activity results for tax purposes within some other, perhaps more viable enterprise on your tax return. For instance, it looks as if Bernie tried to make his cold fusion activity transparent by burying it in the Western partnership operations. If you write fiction part time and work as a lawyer most of the time, don’t bury the profit-and-loss statement of your fiction-writing activity within the profit-and-loss of your law practice. Doing so makes you look like a cheat and a ditz. Don’t do it. It’s not savvy. They are separate activities, for pity’s sake.

To be or not to be; that’s the question. To be a trade or business there has to be enough business activity and profit objective. Get them and you’re home free. Such are measured objectively . . . well, that’s what the laws and courts say, anyway. Tax shelters, for example, often have neither sufficient business activity nor profit objective. Many therefore receive no graces. To be certain, a trade or business can exist with no profits in the early years (and sometimes none are earned for many years and yet a court approves), provided there’s a prospective profit sufficient to cover the losses. You don’t have to expect that profits from your expression activity will come immediately or within a short time, but your aim to profit must be genuine. If challenged, you have to be able to persuade the IRS or a court. If you’ve stacked up $100,000 or more of losses over multiple years, you have to be able to convince the IRS (and if not the IRS, then a judge) that your expression activity will earn enough not only to make an annual profit but to recoup your prior losses.

Why Are People So Greedy?

While working for her husband’s dentistry practice, Karen Cavaretta billed insurance companies for work he hadn’t done. Why? Didn't she have enough, living as the wife of a dentist who made good money? I guess not.

She pled guilty to fraud charges, he then repaid the money, and they deducted the repayments as his business expenses. IRS didn't think the repayment should be a business expense.

Palm Canyon X Investments, LLC

This case involves some celebrity.

Palm Canyon X Investments, LLC through AH Investment Holdings, Inc., its tax matters partner, challenged the IRS in the United States Tax Court. The Tax Court filed its opinion on December 15, 2009. The IRS won the case. The case involves tax shelter-type issues. Palm Canyon, a single-member limited liability company owned by AH Investment Holdings, entered into some contracts known as "offsetting market-linked deposit contracts." So what? you say. Well, it was all important enough for a judge to write a 104 page opinion, including his conclusion that Palm Canyon was a farce --- a sham --- and that the market-linked deposit contracts lacked economic substance and could be disregarded. Of course, I won't be giving all the details here, but it is interesting to note that the case involves the actress, Suzanne Somer, and her husband, Alan Hamel, and the well-known "Thighmaster" exercise equipment.

Furthermore, in this case, the government was represented --- at least in part --- by two of my former colleagues at the IRS, Stephen M. Barns and David Sorenson, who were attorneys with District Counsel. David's office was two or three offices down from mine. Stephen's --- who incidentally went by Mark, his middle name --- worked in an office down the hall and then to the left a couple of offices, almost on the other side of the building. Anyway, I thought that was interesting.

Start-up Expenses, Office-in-the-Home, and More

JOHN Y. DING faced the IRS in Tax Court relative to what they claimed were his "business expenses." He claimed a bunch of expenses relative to his employment and a prospective business he was trying to get off the ground. It results in an interesting discussion and analysis of various matters including start-up expenses versus business expenses, rules governing an office in the home, and documentation, including the application of the Cohen rule.

Fraud and Other Stupidity

Ron and Tricia Bell got greedy. They faced additional taxes and penalties, including ones for fraud. The Tax Court reached a decision on Wednesday.

Big bucks. Interesting story . . . well, maybe not so much. Use your imagination. Check it out if you are interested in cheats.

Another Doctor Claims His Wife's Horse Losses

Wednesday, the Tax Court issued an opinion in a case involving another doctor whose income supported his wife's horsey losses that the IRS said were hobby losses. See the Phemister case to read about it. The case also covers innocent spouse, failure-to-file, and negligence penalty issues.

Bank Deposits Analysis

If a taxpayer fails to file a return, there are several things IRS can do to get around that. If the taxpayer is employed, it gathers the employers W-2s and 1099s and utilizes them to construct what a return would look like. Say, however, the taxpayer is self-employed --- maybe he operates a bookstore or some other retail outlet. What does the IRS do then? Well, if the taxpayer kept checking and savings accounts, IRS might utilize those accounts to reconstruct his income from the deposits in them.

A good example of IRS doing that is a case issued by the United States Tax Court today, the case of BLAKE HYUN SEO. You can view the case at http://www.ustaxcourt.gov/InOpTodays/Seo.TCM.WPD.pdf . I'm not certain how long that link will work, though, because the opinion will only be a "today's opinion" today. However, you can do a search any time using his name on the United States Tax Court webpage and find the case.