Many skeptics and detractors feel operating a yacht as a small business is not a legitimate active participation business. But our experience is that if it is done correctly with a sincere intent to create a small business which will either be profitable in the short term or in the long term through a paid-off asset acquisition, it is the correct business strategy for a yacht owner. It is also an effective tactic to reduce the cost of boat ownership.
We have not only successfully helped many yacht owners to set up a yacht business, but we have done this ourselves with our own boats. It is not simple and you have to keep good records, but the reward is great. Below are various arguments by naysayers against yacht as a business, using the IRS rules as a scare tactic. While we have to be careful about record keeping, we know that if you are diligent and follow the rules, there is no reason not to do this.
Do Your Yacht Activities Qualify As A Business Under The IRS Regulations?
Experts Say: “The IRS’ goal is to deter taxpayers from using a yacht-chartering business as a way to purchase a yacht for personal enjoyment and then deduct losses for the yacht-chartering activities.” Thus, if your activity does not meet the IRS definition of a business, you can’t take business deductions.
Catamaran Guru: The IRS evaluates nine critical factors to determine whether a “business” is run for profit. However, it’s important to know that these factors are open to interpretation.
- How business is conducted: Are you conducting the activity in a business-like manner? Do you keep complete and accurate business records and bank account?
- Expertise: The business owner should have the expertise necessary to run the business or seek you seek (and follow) expert advice.
- Time and effort: Do you spend the necessary time and effort to succeed with the business? However, If the activity has significant personal or recreational aspects, simply spending a great deal of time on it, will not prove a profit motive.
- Asset appreciation: Is it likely that your business assets will appreciate in value over time? A profit motive can exist if gain from the eventual sale of assets, plus any other income, would result in an overall profit even if there’s no profit from current operations. Regs. Sec. 1.183-2(b)(4) says such appreciation may be considered in lieu of current profits.
- Track record of success: Have you in the past, engaged in similar or dissimilar activities and made them profitable?
- History of income or loss: Did the business losses occur because the business was still in a start-up phase, or because of unforeseen circumstances i.e. an economic downturn or hurricane event? If the activity is continued with for many years despite continued losses, it may indicate that the activity is a hobby.
- Relative amounts of Profits & Losses: Are the amounts of occasional profits insignificant when compared to the size of your investment in the activity, and the amounts of losses suffered in other years? Regs. Sec. 1.183-2(b)(7) states, “The amount of profits in relation to the amount of losses incurred, and in relation to the amount of the taxpayer’s investment and the value of the assets used in the activity, may provide useful criteria in determining the taxpayer’s intent.” However, the presumption of profit motive in Sec. 183(d) says that if an activity has gross income for three or more of the last five years that exceeds the deductions attributable to the activity, the activity generally is presumed to be for-profit.
- Owner’s financial status: Is the business activity your only source of income? Few people base their continued economic survival on the happenstance of a hobby.
- Personal pleasure or recreation: Is the business of a type that is not usually considered to have elements of personal pleasure or recreation? This may, with other factors, indicate lack of a profit motive
Experts Say: ”If your yacht charter business has not made a profit in three out of the last five years (and not just some minimal profit, but a significant profit relative to other factors), the odds are against your charter activity qualifying as a business according to the IRS”.
Catamaran Guru: The business owner needs to be able to definitively show that he has the intent and ability to make a profit and then the three out of five standard will not apply. Form 5213 lets you officially elect to have the IRS wait until the first five years are up before examining the profitability of your business. Form 5213 should be filed within three years of the due date of the return for your first year in business. However, if you haven’t filed the form and the IRS audits you, you can file the form within 60 days of receiving the IRS notice, as long as your three-year period has not expired.
Experts Say: “So, how much net profit does your charter business generate? As a matter of fact, few yacht charter activities earn any net profits – much less significant profits three out of five years. Thus many fail to qualify as legitimate business enterprises”.
Catamaran Guru: True, but if structured correctly with the right strategic partners, the right type of yacht and the right location, the business can show a reasonable taxable profit. The model will be able to show the intent and ability to make a profit.
Documentation To Prove Business Activity
List of Documents For An Audit
Every yacht owner claiming tax benefits from yacht charter activities should be prepared to provide the IRS with this information. Below is a listing of possible items an examiner might request to assist in determining if a yacht charter activity is an activity engaged in for profit.
- Statement of taxpayer’s boating experience:
Catamaran Guru: If the business is a bareboat operation, the owner does not need to have a captain’s commercial qualification although it would help.
- Copies of experience profiles submitted by potential charterers:
Catamaran Guru: Depends on where the charter takes place. In Europe an ICC license is required. In the Caribbean the customer needs to prove ability and a track record if there is no formal qualification available. It is not required by law in all cruising areas.
- Purchase agreement, Bill of Sale and Invoice, and all canceled checks showing verification of yacht purchase:
Catamaran Guru: All readily available
- Statement of actions taken to investigate boat-chartering business before entering into this business:
Catamaran Guru: The owner of the business should draw up a business plan based on the fundamentals of the business to show the viability and the ability to make a profit, before entering into the business venture.
- Name and address of all charterers and their lease agreement:
Catamaran Guru: This is easily provided. There are about an average of 20 -30 charters a year, and these records are usually kept by you or the booking company whom you pay a fee of 10-20% of the charter fee.
- Schedule of fees or charges billed to charters:
Catamaran Guru: That is part of the monthly / quarterly accounting function.
- Copies of original loan agreements/promissory notes on financed portion of property:
Catamaran Guru: Provided at closing of vessel purchase:
- Insurance policy(s) on yacht and its contents (collision and liability). Note to examiner: Does policy cover rental of boat? Is it a commercial or personal asset?
Catamaran Guru: This is normal and customary; the business has an insurance policy with the lender (if there is one) and the business as the loss payees. The policy covers all risks and commercial activity
- Copy of First Preferred Ship Mortgage:
Catamaran Guru: Loan documents will stipulate the guarantor and lien holder. The insurance document will stipulate the first loss payee, usually the mortgage holder and lien holder.
- Promotional materials and charter sailing brochures for yacht:
Catamaran Guru: The brochures and advertising materials of the contractor who co-manages the yacht would be available. Each owner is also encouraged to create a website and set up social media accounts for promotions.
- Invoices and ad copies for advertisements on availability of yacht for rental:
Catamaran Guru: The owner of the business should attend at least one trade show a year to promote the business and keep diligent records of time and expenses.
- Copies of any management agreements or management contracts for boat supervision, maintenance, or operation:
Catamaran Guru: The management agreements with agents, or co-management partners should be negotiated annually to ensure that they are market related and in the best interests of the business. A 5-year contract with the management company DOES NOT qualify.
- Ships log(s) for engine and/or boat use:
Catamaran Guru: A log should be kept of the owners’ personal use, which should be kept to a minimum. Based on the IRS tests for active participation the owner should ensure that they have a minimum of 100 hours per year logged and that they do more work in the business than any other one person. Administration does not count so be sure that the hours logged are well in excess of 100 hours in case time is disallowed in the event that the business is scrutinized.
- Maintenance records and service check performance records:
Catamaran Guru: The management company would be required to keep these and produce them on demand.
- Certificate of Origin:
Catamaran Guru: Provided to the buyer upon purchase.
- Certification of Documentation from U.S. Coast Guard:
Catamaran Guru: This document is provided at closing. Original document is always available on the vessel.
- Copy of commercial captain’s license:
Catamaran Guru: Depends on where the charter takes place. In Europe an ICC license is required. In the Caribbean the customer needs to prove ability and a track record if there is no formal qualification available. It is not required by law in all cruising areas.
- Shipping document or other records, which verifies delivery date of property:
Catamaran Guru: Bill of sale indicates delivery date, generated at closing.
- Yacht operating budgets:
Catamaran Guru: Should be in the business plan – there are also financial projections that should be included in the records
- Break-even point calculations for chartering activity:
Catamaran Guru: This is usually in the business plan and part of the financial projections.
- All books and records pertaining to the boat business:
Catamaran Guru: The CPA should keep the business books and generate the K1 for the business owners consolidated accounts.
- Please complete a Schedule of Boat Use and Schedule of Taxpayer/Shareholder/Partner Time Spent to Operate the Activity of Boat Chartering.”:
Catamaran Guru: Keep a log of all time both personal and business activity on the boat and in the business.
Consult With Catamaran Guru
If you have any questions or concerns about your yacht charter activities complying with IRS regulations or would like to learn how we can make your yachting ventures more profitable, please contact us for a confidential assessment and review.
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* Disclaimer: This information is general in nature and purchasers are encouraged to seek experienced legal counsel in yacht acquisition planning and implementation. Catamaran Guru is not a licensed Tax Attorney or CPA and is not qualified to give legal advice but we can put you in touch with experts who are.
