John and Kathy Brown have just been audited and the IRS agent disallowed the business loss they claimed in 2013. The agent asserted that the activity was a hobby, not a business.
John and Kathy live in Rochester, New York, near Lake Ontario. Kathy is a CPA, and John was formerly employed by an insurance firm. John’s firm moved in 2008 and John resolved not to move to the firm’s new location. Instead of seeking other employment, John felt he could supplement his income by using his fishing expertise. He had been an avid fisherman for 15 years, and he owned a large Chris-Craft fly-bridge that he chartered to paying parties.
In 2009, Kathy and John developed a business plan, established a bank account for the charter activities, developed a bookkeeping system, and acquired insurance to cover the boat and the passengers. John fulfilled all the requirements to receive a U.S. Coast Guard operating license, a New York sport trolling license, and a seller’s permit. These licenses and permits were necessary to legally operate a charter boat. The first year of their activity was 2009.
John advertised in local papers and regional sport fishing magazines. He usually had three or four half-day paying parties each week. John spent at least one day per week maintaining and repairing his boat. Kathy usually accompanied John on charters three or four times each year.
John’s charter activity was unprofitable the first two years. In 2011, John and Kathy restructured the activity to improve profitability. The restructuring included increasing advertising, participating in outdoor shows, and negotiating small contracts with local businesses. After the restructuring, the activity provided a small profit in 2011 and 2012.
In 2013, John started working with another insurance company in the area on a full-time basis. Even though he returned to the insurance business, John normally took two paying parties and one nonpaying, promotional party each week throughout the fishing season. John’s costs unexpectedly increased and he lost $8,000 in the activity during 2013. John and Kathy deducted the entire loss on Schedule C of their 2013 tax return.
Required:
Prepare a memo to the Browns recommending what position they should take and why. Show the logic used in arriving at your recommendation.