On March 7, 2022, the Tax Court issued a Memorandum Opinion in the case of Walters v. Commissioner (T.C. Memo. 2022-17). The primary issue presented in Walters v. Commissioner was whether the petitioners’ mutually owned partnership was engaged in for-profit activities in constructing “green” homes.
Background to Walters v. Commissioner
Petitioner Jessica Walters (petitioner daughter) resided in North Carolina when she timely filed her petition, and petitioners David Walters (petitioner husband) and Jean Walters (petitioner wife) resided in Georgia when they timely filed their petition. Petitioners are all partners of D&J Properties (sometimes referred to as the partnership), a Georgia partnership, with petitioner wife and petitioner husband each holding a 47.4% interest and petitioner daughter holding a 5.2% interest. Petitioner husband serves as the managing partner of the partnership.
Petitioner husband and petitioner wife sold their businesses in Michigan and in 1986 opened two La-Z-Boy stores in Georgia. By 1988 they had opened two more La-Z-Boy stores. D&J Properties owned three buildings that housed the La-Z-Boy stores. At the time, the La-Z-Boy stores produced approximately $20 million in annual revenue.
In 1994 petitioner husband invested in Waste Alternative, a private company that focused on removing plastic waste from Florida streams, and he subsequently joined its board of directors. Petitioner husband remained on the board for three years until the company was successfully sold for a profit.
As green construction organizations developed over the years, petitioner husband followed the industry, attending several seminars. Through these seminars petitioner husband became acquainted with what was required to obtain certification of a building under Leadership in Energy and Environmental Design (LEED) standards. Over the last ten years, petitioner husband has guest-lectured at Western Carolina University in their construction management program.
In the late 1990s petitioner daughter received her undergraduate degree in environmental science and political science. After receiving her degree, petitioner daughter obtained her law degree from a school that offered a focus on environmental law. During law school, petitioner daughter interned at the Carolina Mountain Land Conservancy where she met various individuals, including land developers, who invested in eco-friendly developments.
Transition to Eco-Friendly Commercial and Residential Construction/Consulting Business
After completing law school, petitioner daughter expressed her wish not to enter into the furniture store business with petitioner husband and petitioner wife. In 2004 petitioners considered transitioning D&J Properties into an eco-friendly commercial and residential construction/consulting business by entering the green real estate market. As part of that plan, the partnership sold its La-Z-Boy furniture stores but retained ownership of the three stand-alone buildings that housed the stores.
Through connections petitioner daughter made at her internship with the conservancy, petitioners became aware of Balsam Mountain Preserve (BMP). BMP is a low-density housing development in the mountains of North Carolina that places particular emphasis on land conservation. In February 2006 the partnership purchased a lot in BMP. In May 2006 contractors involved in building green structures met with petitioners to inspect the BMP property and begin plans to build a green home (Balsam Home) on the lot. Balsam Home was completed in 2009 and was awarded the USGBC LEED for Homes Gold Certificate (the highest LEED certification for homes) in April 2010.
From 2010 and until at least the time of trial, D&J Properties advertised as a green company in the Western North Carolina Green Building Directory and listed Balsam Home as D&J Properties’ address. D&J Properties also engaged in other marketing campaigns that highlighted Balsam Home and its features.
From the time Balsam Home was completed, petitioners kept the house open for tours. The partnership depicted Balsam Home as a model show home in advertisements and interviews. Individuals viewing the home would see the various certificates awarded to Balsam Home prominently displayed on the entryway walls. Additionally, pamphlets about green construction and a book highlighting the various green construction features of Balsam Home were placed on a coffee table for viewers. The upkeep of Balsam Home is labor intensive; the various features of the home do not permit the home to remain unattended for extended periods. Petitioners employed a landscaping crew to assist with maintenance but performed most of it themselves. Additionally, petitioner husband occasionally used the golf course.
The Main Issue in Walters v. Commissioner
The main issue in these cases is whether D&J Properties was engaged in a for-profit green construction/consulting business through the construction and promotion of Balsam Home, as petitioners contend, or whether petitioners used Balsam Home for personal use and enjoyment, as the IRS contends.
For Profit Activities, Generally
Generally, taxpayers may deduct business-related and investment expenses. However, under IRC § 183(a), taxpayers may not deduct expenses for an activity “if such activity is not engaged in for profit.” When a partnership is involved in an IRC § 183 analysis, the existence of the requisite profit objective is determined at the partnership level. The analysis typically focuses on the actions of the partners who manage the affairs of the partnership and upon whom other partners rely to make partnership decisions. Therefore, whether the construction and maintenance of Balsam Home by D&J Properties constituted a for-profit activity depends on whether the partnership, through the actions of its managing partners, had a bona fide profit objective or intent.
Treasury Regulation § 1.183-2(b) provides a nonexclusive list of objective factors to be considered in deciding whether an activity is engaged in for profit. Your beloved editors at Briefly Taxing previously wrote an article on the test for profit motive under IRC § 183. Check it out here.
The profit-motive factors are:
- the manner in which the taxpayer carries on the activity;
- the expertise of the taxpayer or the taxpayer’s advisors;
- the time and effort expended by the taxpayer in carrying on the activity;
- the expectation that assets used in the activity may appreciate in value;
- the success of the taxpayer in carrying on other similar 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.
No single factor is determinative, and all facts and circumstances should be considered. Moreover, the Tax Court does not resolve the issue of profit objective by simply comparing the number of factors indicating profit objective with those indicating the lack of such an objective. It separately addresses each factor.
Manner in Which the Taxpayer Carried on the Activity
The fact that the taxpayer carries on the activity in a businesslike manner and maintains complete books and records may indicate that the activity was engaged in for profit.
Petitioners point to the display of accolades, pamphlets, and books detailing Balsam Home’s green features for individuals touring Balsam Home as evidence that the home was run in a businesslike manner as a show home rather than a private residence. Furthermore, petitioners cite the partnership’s accounting method of coding each expense to the correct business project and consistent meetings with an accountant as support for their position.
While the partnership’s books are replete with what might appear on their face to be personal purchases, the partnership maintained thorough records which might support a conclusion that it operated Balsam Home in a businesslike manner. The thoroughness of the records would have allowed the partnership to abandon unprofitable operating methods or improve its techniques in the future, which is consistent with having a bona fide profit objective. Moreover, Balsam Home continually stood ready for tours and was held out to be a green residential show home. Considering the foregoing, the Tax Court concluded that this factor is neutral.
The Expertise of the Taxpayer or the Taxpayer’s Advisors
A taxpayer’s expertise, research, and study of an activity, as well as his consultation with experts, may be indicative of a profit objective.
The petitioners contend that the petitioner husband has extensive knowledge in “green building science” as displayed through the construction of the eco-friendly stand-alone building in Georgia and the various seminars he has taken over the years regarding eco-friendly construction. The IRS, on the other hand, contends that the petitioners do not have any particular expertise in eco-friendly residential construction.
The Tax Court concluded that the petitioners’ individual knowledge in the eco-friendly construction field is sufficient for this factor to weigh in their favor, as the petitioners used this knowledge to collectively further the business of the partnership.
The Time and Effort Expended by the Taxpayer in Carrying on the Activity
The fact that the taxpayer devotes much of his personal time and effort to carrying on an activity, particularly if the activity does not have substantial personal or recreational aspects, may indicate an intention to derive a profit.
The petitioners contend that the countless hours of overseeing the construction of Balsam Home, advertising, meeting with real estate developers, attending seminars, hosting seminars, and ensuring Balsam Home received various residential green certifications all furthered D&J Properties’ green real estate venture. The IRS contends that the petitioners were often at Balsam Home not to network but to enjoy the area, focusing on the fact that the petitioners visited the area during holidays and that the petitioner husband spent a substantial amount of time at Balsam Home.
The Tax Court found the petitioner-husband’s testimony credible. Although the petitioners employed a landscaping crew to assist with maintenance, they performed most of the maintenance themselves. Additionally, the petitioners’ work in furtherance of D&J Properties’ business was not limited to the upkeep of Balsam Home or spending time at BMP. Thus, the Tax Court concluded that this factor weighs in favor of the partnership’s having a profit objective.
Expectation That Assets Used in the Activity May Appreciate in Value
An expectation that assets used in the activity may appreciate in value may be an indication of a profit objective. The IRS conceded this factor. Because the asset (Balsam Home) is real estate, the expectation is that the home would appreciate in value.
Success of the Taxpayer in Carrying on Similar or Dissimilar Activities
The fact that the taxpayer has engaged in similar or dissimilar activities in the past and converted them from unprofitable to profitable enterprises may indicate that he is engaged in the present activity for profit, even though the activity is presently unprofitable.
The petitioners contend that the success they had in establishing three profitable businesses in Michigan, selling those businesses, and then establishing multiple successful La-Z-Boy stores in Georgia along with constructing stand-alone buildings, supports their claim that the partnership entered the green real estate industry with a profit objective.
The IRS contends that (1) the petitioners themselves are not successful entrepreneurs, as they have not reported a profit from their business dealings in Georgia or for D&J Properties since 2009, and (2) the petitioners were not seeking success in the green construction industry but, rather, wanted to use the losses to offset any gains they received from the commercial properties in Georgia.
The Tax Court disagreed with the IRS, as the partnership’s business was in the real estate industry, which, starting in 2008 and became a largely unprofitable industry because of the “Great Recession.”
Regarding the IRS’s second point, we are persuaded that the petitioners, themselves, have experience in successfully entering new markets, as evidenced by their selling their businesses in Michigan to start again in Georgia. Thus, the Tax Court concluded this factor weighs in favor of the partnership’s having a profit objective.
The Taxpayer’s History of Income or Loss with Respect to the Activity
A series of losses during the initial or startup stage of an activity may not necessarily be an indication that the activity lacks a profit objective. However, where losses continue to be sustained beyond the period which customarily is necessary to bring such an operation to profitable status, such continued losses, if not explainable, may be indicative that the activity is not engaged in with a profit objective. If losses are sustained because of unforeseen or fortuitous circumstances which are beyond the control of the taxpayer, such as depressed market conditions, such losses would not be an indication that the activity lacks a profit objective.
The parties agree that the partnership has not realized a profit from its green residential construction/consulting business. Petitioners contend that this lack of profit is due to the unfortunate timing of the partnership’s entering the green real estate market at the forefront of the “Great Recession.”
The Great Recession began at the end of 2007. Balsam Home, the center of the partnership’s marketing strategy, was not completed until 2009. Nothing in the record suggests whether the failure to generate a profit from 2004 until the Great Recession was due to the lack of profit objective. The record does not establish that the economic downturn alone explains the continued sustained losses, but neither can the effect of the economic downturn be ignored. Therefore, the Tax Court concluded that this factor is neutral.
The Amount of Occasional Profits, if Any, Which Were Earned
The amount and frequency of occasional profits earned from the activity may also indicate a profit objective. An opportunity to earn a substantial ultimate profit in a highly speculative venture is ordinarily sufficient to indicate that the activity is engaged in for profit even though losses or only occasional small profits are generated.
The petitioners contend that while the partnership did not make a profit from its green real estate venture, a substantial ultimate profit from its various activities related to Balsam Home was expected. Petitioners point to discussions with clients suggesting that two of their projects had substantial earning potential. The IRS, however, contends the petitioners have not provided any credible evidence for these anticipated profits.
While the petitioners suggest that the green real estate market is highly speculative, the record does not support that conclusion. We have previously found that the residential real estate market is not highly speculative, and the petitioners have not explained why they considered the green residential real estate market to be highly speculative. On the basis of the foregoing, the Tax Court concluded that this factor favors IRS.
The Financial Status of the Taxpayer
Substantial income from sources other than the activity, particularly if the losses from the activity generate substantial tax benefits, may indicate that the activity is not engaged in for profit.
Petitioners contend that neither the partnership nor its members had substantial income from other sources, indicating that the partnership sought profit specific to the Balsam Home green real estate venture. Petitioners draw attention to the fact that (1) by the end of 2012 only one of the partnership’s three buildings in Georgia had a tenant, (2) in 2013 the petitioners had to borrow money from the petitioner-husband’s father to avoid foreclosure on one of the properties, (3) in 2013 and 2014 the partnership had to sell two of the buildings, and (4) the remaining building had only periodic tenants once a year.
The IRS contended that the petitioners themselves have amassed a large amount of wealth, which supports a conclusion that the partnership did not have a profit objective.
Upon the initial construction of Balsam Home, the petitioners were indeed benefiting from significant rental income from the partnership-owned Georgia properties and the deductions associated with Balsam Home allowed them to offset that income. However, that rental income was not steady during the years in issue. Additionally, the petitioner-wife credibly testified during trial that to make the monthly mortgage payments for Balsam Home, the petitioner-husband and the petitioner wife had to use funds from their savings.
The Tax Court agreed that the petitioner-husband and the petitioner-wife’s stated monthly income of $40,000 supports the IRS’s contention that they had significant income to offset. Further, the over $3 million in assets comprised their respective interests in Balsam Home (which was appraised at around $3 million) and their personal residence. Overall, the facts of this case show a varying income, particularly over the years in issue. The Tax Court concluded that this factor was neutral.
Elements of Personal Pleasure or Recreation
The presence of personal motives in the carrying on of an activity may indicate that the activity is not engaged in for profit, especially where there are recreational or other personal elements involved.
Petitioners contend that the partnership did not build Balsam Home for their personal enjoyment and that all their trips to BMP were work related. During trial, the petitioners testified that they did not go to Balsam Home for pleasure but to keep the house in operating condition so that it was always ready to show at a moment’s notice.
Petitioners maintained that the only amenities they used at BMP were the restaurant and the golf course on three occasions for networking purposes. Additionally, the petitioner-husband testified he placed wine in the cellar to prepare Balsam Home to be photographed. The broker in charge at BMP testified that BMP has the most people present during holidays and that BMP governance does not allow business signage to be used in front of homes.
The IRS contends that the petitioners built Balsam Home for personal pleasure and highlights the various amenities at Balsam Home and BMP. The IRS points to the facts that the petitioners
- listed all of their vehicles on the membership form;
- included “the Walters” in the voicemail for one of the landlines and for the signage in front of the home (rather than D&J Properties);
- stored wine bottles in the wine cellar;
- used the golf course at BMP; and
- purchased an extensive cable package.
The Tax Court “appreciated” the fact that it can be difficult to separate from business use the pleasure an owner may receive from visiting a home in a mountain resort, particularly when attempting to prove a negative (that the petitioners did not build or visit Balsam Home for their personal pleasure or recreation). Overall, the record neither supports nor refutes the presence of pleasure or recreation as a primary motivating factor in building and operating Balsam Home. As such, this factor was neutral.
Conclusion in Walters v. Commissioner
The factors of this case support a conclusion that the partnership was engaged in a for-profit activity. The Tax Court observed that the partnership’s efforts were not perfectly executed, but its actions overall fall in favor of a conclusion that it was seeking a profit.
(T.C. Memo. 2022-17) Walters v. Commissioner
- See IRC § 162; IRC § 212. ↑
- Brannen v. Commissioner, 78 T.C. 471, 505 (1982), aff’d, 722 F.2d 695 (11th Cir. 1984). ↑
- See id. at 504-05. ↑
- See id. ↑
- Allen v. Commissioner, 72 T.C. 28, 33 (1979). ↑
- Treas. Reg. § 1.183-2(b). ↑
- Id.; see also Abramson v. Commissioner, 86 T.C. 360, 371 (1986). ↑
- Treas. Reg. § 1.183-2(b). ↑
- Treas. Reg. § 1.183-2(b)(1). ↑
- See Treas. Reg. § 1.183-2(b)(1). ↑
- Treas. Reg. § 1.183-2(b)(2). ↑
- Treas. Reg. § 1.183-2(b)(3). ↑
- Engdahl v. Commissioner, 72 T.C. 659, 668 (1979); Treas. Reg. § 1.183-2(b)(4). ↑
- Treas. Reg. § 1.183-2(b)(5). ↑
- Treas. Reg. § 1.183-2(b)(6). ↑
- Treas. Reg. § 1.183-2(b)(7). ↑
- Pouemi v. Commissioner, T.C. Memo. 2015-161, at *10, aff’d per curiam, 633 F. App’x 186 (4th Cir. 2016). ↑
- Treas. Reg. § 1.183-2(b)(8). ↑
- Treas. Reg. § 1.183-2(b)(9). ↑
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