We have seen many yacht businesses operated in charter programs very successfully around the world as small businesses by our clients. Offsetting the cost of ownership is a sound strategy especially in the yacht charter business. However, there are many regulatory challenges to a yacht charter program, including complex tax laws, IRS regulations, active participation rules, profit motive, and other business considerations.
Your endeavor may be considered a "business" by the IRS if you can show ability and show a legitimate effort to make a profit. Learn more about Section 179 tax deductions for yacht charter businesses. This allows you to deduct all expenses relating to the business operation from the business income tax report. Losses shown in the early years of ownership can be used to offset other income such as income from other trade or business, investment earnings, or wages from another job.
But before you start applying your charter losses against income, it is essential that you understand how the IRS might evaluate your “business.” The tax code is clear enough and there are several Tax Court cases on the issue of yacht chartering and so-called “hobby loss” and “active participation” rules. One tax court case in 2015 gave a lot of support for running chartered yachts as a bona fide business.
On the other hand, if the IRS treats the activity as a "hobby," the tax benefits are more limited and you should know the difference. The IRS regulations itemize nine factors that determine whether a particular activity is a business or a hobby. Some of the things that the Courts (and the IRS) will consider:
No single thing is conclusive, but a combination of factors can tip the scale in your favor or against you. However, you may have a bit of an uphill battle when an activity involves entertainment or recreation. Being the owner of a yacht and yacht charter activity are prime targets because people either abuse it or fail to set the business up correctly from the start. The IRS give less leeway to these types of “businesses”, but there is good news. The Tax Court says that: "A business will not be deemed a hobby merely because the owner enjoys the activity". You will be subject to a number of tax rules as a charter boat operator, so its important that you plan and operate the business so that you meet all or most rules to make a successful business. Catamaran Guru can help you set up your business and guide you on the finer points to document and important aspects of operating a charter yacht that provide evidence in case of a dispute.
If you are in the market for a new boat and pay a lot of taxes, you may want to take a close look at this law to help you offset the cost of ownership. If you want to take advantage of this program this year, you have to act swiftly. Inventory is low and time is of the essence.
Below are some cases that illustrate the court interpretations of tax law as laid out by Nick G. Tarlson, CPA.
"Jackson v. Commissioner, 59 T.C. 312 (1972). Thomas was an unmarried individual residing in New York City and serving as an officer and shareholder in two executive search firms. He purchased a 65 foot ketch for $7,000 and rebuilt it over a period of three years, then chartered it for use in the Caribbean, South Pacific and Long Island Sound. In 1965, the taxpayer earned $30,000 in gross revenues, and made a small profit. In 1966, however, he only collected $2,250 in revenue, and deducted $20,505.41, including $7,100 to his brother, Peter, who served as a captain for the ship, and $2,721.08 to the ship’s crew costs, which included Peter’s wife Constance, resulting in a substantial loss. The IRS sought to disallow the loss, claiming the activity was a hobby. The Tax Court allowed the loss, based on its conclusion that the taxpayer intended to make a profit, engaged in sound and reasonable efforts to enter the Caribbean charter business, which is a common business enterprise, staged a thorough advertising campaign, and contacted numerous charter brokers and travel agents, efforts which were ultimately successful. Were it not for adverse weather conditions and resulting delays, he may well have been profitable in 1966. Thomas’s personal use of the vessel was limited, as was his income. The court found that a business will not be turned into a business merely because the owner finds it pleasurable, citing Wilson v. Eisner: “Success in business is largely obtained by pleasurable interest therein.”23 No weight was given to the IRS contention that the activity was intended primarily to provide an occupation for Peter and Constance. The deductions were allowed, and the negligence penalties disallowed, including those imposed under the theory that failure to maintain records constitutes negligence.24
Editor’s note: this Tax Court case makes it clear that there is a difference between “intending to make a profit,” which is required for business deduction treatment, and actually making a profit. We encourage our clients to keep close tabs on their actual results of operations compared to their budgets and projections. Even though this taxpayer was lucky enough to avoid negligence penalties for failing to maintain proper records, it goes without saying that the better your recordkeeping, the better your chances for success if you are ever challenged by the tax authorities."
"Goshorn v. Commissioner, T.C. Memo 1993-578. William and Virginia resided in Dallas, Texas, where they purchased a 29 foot sailboat for $50,000. William’s employer, United Parcel Service, transferred him to Connecticut, but he left the sailboat at Lake Texoma and entered into an arrangement with Cedar Mills Marina to rent out the boat for charter for a stipulated management fee. The Marina’s crew would spend 30-90 minutes preparing the boat for each charter, and the Marina’s charter representative would spend 30-45 minutes performing checkout procedures to familiarize the customer with the boat and check the boat’s inventory. After the charter, the crew and charter representative would spend about 2 hours inspecting and cleaning it. During 1988, the sailboat was chartered 12 times for a total of 23-1/2 days. The taxpayer visited Dallas 14 times in 1988, spending 8 hours per trip for on-site inspections of the boat and another 8 hours per month performing budget accounting relating to the boat, but he kept no contemporaneous records concerning this time expenditure. He testified that he spent over 300 hours materially participating in the business, and 600 hours if you include the travel time from Connecticut to Dallas and Dallas to Lake Texoma. The court disallowed the deductions, characterizing the taxpayer’s estimate as a “post event ballpark guesstimate,” concluding that the Marina performed most of the activity directly related to the rental of the boat, and characterizing much of the taxpayer’s activity as that of an investor, not allowable as material participation under the regulations.
Editor’s note: this case teaches us several lessons. The premise is that the taxpayer needs to spend at least 100 hours and more than any other individual materially participating in the activity. At the outset, you should make sure you have your material participation formulas spelled out in the business plan. Here, the wide range in time estimates, prepared after the fact, made it look like the marina personnel spent 3 to 4.25 hours per charter prepping, checking out, inspecting and cleaning the boat. That’s probably close to the amount of time the customer spent on the boat! Our interviews with local charter agents indicate a much lower turnaround on each charter, particularly considering online reservation systems and other time efficient operational techniques. This taxpayer made the mistake of not keeping contemporaneous records, which undermined his credibility. He also failed to distinguish his participation from that of a passive investor."
"Lucid v. Commissioner, T.C. Memo 1997-247. Morgan was a plastic surgeon and Mary a psychotherapist residing in Fresno, California, both experienced sailors with trans-Pacific, trans- Atlantic, and Caribbean cruising experience. They formed a corporation to engage in the sale of yachts and boating equipment. Over five years’ time, they received $1,442 in sales revenue and deducted $496,827 in losses from the activity against their earned income of $229,757 to $346,593 per year during the same period. The Court denied the losses, pointing out that they had no written business plan and did not take reasonable steps to evaluate and implement the business.
Editor’s note: no business plan, no planning or analysis, no deductions!"
"Oberle v. Commissioner, T.C. Memo 1998-156. The Tax Court disallowed losses from yacht charter activity where the taxpayers could not show that they met the material participation rules. Thomas was a stockbroker at Dean Witter Reynolds and Margaret was a real estate broker for Price Realtors, Inc. They purchased a 38 foot yacht in 1993 for $143,000 and placed it in a 7- year Charter Brokerage Agreement with Michigan City Sailboat Charters, Inc. in Michigan City, Indiana. Under the agreement, the broker received a brokerage commission of 50 percent of the charter revenue in exchange for providing enumerated services. Although the taxpayers may have established that they devoted more than 100 hours per year to the activity, they failed to show that they devoted more time than the broker, so the deductions were disallowed.
Editor’s note: assuming the broker is business and not a single individual, this adverse decision may have been the result of an imprecise reading of the passive activity rules. It is not the broker’s time which is relevant, but rather the time of each individual employed in the broker’s operation."
"O’Connell v. Commissioner, T.C. Memo 2001-158. Thomas was an insurance executive residing in Chula Vista, California. An Avid fisherman, he purchased an ocean going yacht for tournament billfishing in 1982 for $600,000. During the ensuing seven years, he collected gross revenue of $79,500 to $619,504 and recognized losses of $61,391 to $404,280. In 1984, he recognized a net profit of $67,494. The court disallowed the losses, concluding there was no profit motive based on the history of losses and the taxpayer’s testimony, which indicated that profits would be unusual and unexpected.
Editor’s note: this taxpayer never documented his business premise and, therefore, his loss deductions were disallowed, despite the fact he collected substantial revenues and even made a significant profit one year."
"Kline v. Commissioner, T.C. Memo 2105-144. Larry Kline was a captain at Southwest Airlines who started a catamaran charter business in the British Virgin Islands on his retirement at age 60. He purchased two 2006 Lagoon 440s in 2005 and 2008, placing them in a management program with Horizon Charters, which marketed, booked, kept records of, and collected money from charter customers while cleaning and maintain the boats. Kline chartered the vessels for four weeks each year while actively advertising and marketing the boats to pilots at Southwest and other airlines. He and Ms. Kline, a nutritionist, spent considerable time planning and executing these charters, identifying their shipmates’ dietary preferences and planning a healthful diet for the trips. Horizon estimated that some of its employees spent a maximum of 36 to 37.3 hours per year cleaning the vessels. The Tax Court found that the Klines spent more than 100 hours per year materially participating in the business, and that they spent more time than any individual at Horizon. Although the IRS argued that Horizon employees must have spent more time in connection with the activity than the Klines, because they were not directly involved in the business. But the Court cited Section 1.469-5T(a)(3), which requires that participation be measured on an individual basis and not on the basis of the time spent by all members of a management agency. It specifically distinguished this case from Goshorn, above, in that respect.
Editor’s note: This Tax Court case clarifies the test for material participation involves comparing your activity only to other individuals, and not to an entity as a whole, such as a yacht management company."