For some, the allure of tropical breezes, calm waters and retirement aboard a beautiful new yacht traveling the world seems satisfying. For others, the slow boat to nowhere may not be enough, and to offset the restless pursuit of tranquility, as well as expense, a charter strategy is introduced to yacht ownership and operations.
Over the years, we have seen many seasonal and full-time charter programs operated by clients around the world meet with success. In some cases, they experience frustration.
Recently we have seen an increase in IRS scrutiny and audits of yacht charter operations in which the IRS challenges business expenses and depreciation claimed by taxpayers. There are many regulatory challenges to a charter program for a yacht, which include complex domestic and international law, regulations, safety and insurance considerations. If all of this is not enough, federal and state tax treatment of such operations is additionally tricky for anyone not up on the law.
For any new business, and specifically yacht charter, it is not unusual to generate a loss in the first several years of operation. Before applying your charter losses against your income, it is essential that you understand how the IRS might evaluate your business. In addition to the IRS code and any applicable state law, there are numerous tax court cases on this issue of yacht chartering and so-called “hobby loss”. The facts of these cases widely.
Fundamentally, if you are trying to make a profit in an endeavor, it may be considered a business by the IRS. In this case, generally, you can deduct the full amount of expenses relating to the business operation. Again, typically, you might show losses in the early years of ownership. These losses can conceivably be used to offset other income, such as investment earnings or wages from a full-time job – yours, your spouse’s, or both.
On the other hand, if the IRS treats the activity as a hobby, the tax benefits are more limited. Expenses can be deducted only up to the amount of the income received from the charter activity. Thus, you can’t apply your charter losses against non-charter income and claim an overall tax loss for the year.
Even more punishing, hobby loss expenses must be deducted as miscellaneous expenses. Miscellaneous expenses are deductible only to the extent that the annual total exceeds 2 percent of your adjusted gross income. So you may derive little or no tax benefit from your losses.
Business or hobby?
How can one distinguish a business from a hobby? A number of factors must be considered, but in general, an activity is treated as a business only if you are operating it with the actual intention of turning a profit. Though IRS regulations itemize nine factors, determining whether a particular activity is a business or a hobby is an art, not a science. Courts and the IRS will consider:
• The manner in which the taxpayer carries on the activity.
• The expertise possessed by the taxpayer and any advisers.
• The time and effort spent on the activity.
• Any expectations the taxpayer has that assets used in the activity will appreciate in value.
• Prior success in carrying on other activities.
• The history of income or losses with respect to the activity.
• The amount of profits, if any, that are earned.
• The financial status of the taxpayer.
• Any elements of personal pleasure or recreation.
No single factor by itself is conclusive, but a preponderance of factors can tip the scales in your favor or against you. If you operate your yacht chartering profitably, a tax presumption may be on your side. If you showed a profit in any three out of the last five consecutive years, the IRS may agree that you are carrying on a business.
The IRS can rebut the tax law presumption by providing evidence that the activity is actually a hobby. For example, personal use and enjoyment of your yacht exceeding charter use compounded with consistent losses may present an issue. In addition, depreciation conventions and bonus depreciation programs all shift with the political winds and the economy, and offer a matrix of very complicated regulations and trappings for the uninformed.
Simply stated, you may fight an uphill battle when an activity involves entertainment or recreation. The IRS tends to give less leeway to these types of endeavors. However, there is some good news. The tax court makes this point in many cases: A business will not be deemed a hobby merely because the owner enjoys the activity.
The above is merely an outline of some important planning issues which must be considered before commencing a charter program. Securing the advice of a seasoned tax advisor familiar with this specific area is equally as important as hiring competent charter management and marketing the vessel for charter.
David M. Bohonnon is a partner in the Bohonnon Law Firm, LLC, which practices extensively in Marine and Aviation Law as well as tax matters. For more information, visit www.bohonnon.com.