The Court of Federal Claims recently held in favor of a taxpayer who argued that his multiple business entities operated as a unified business enterprise for U.S. income tax purposes. The taxpayer’s winning contention was that his separate and legally distinct entities operated as a unified business enterprise and therefore should be treated as a single business for income tax purposes. The taxpayer’s novel argument provides new opportunities for tax refunds and creative business planning.
The taxpayer in Morton v. U.S. offset taxable income from profitable entities with the deductible expenses and losses of his aircraft company, which the IRS argued was impermissible under the hobby loss rules. Ultimately, Peter Morton, a co-founder of the Hard Rock Cafe, was held to be legally entitled to net his losses generated from the use of his aircraft that was owned by a separate entity against his otherwise taxable income generated by his other separate profitable ventures. The Court of Federal Claim’s decision upheld Morton’s claimed multimillion-dollar income tax deduction from his aircraft company while avoiding related interest and penalties claimed owing by the IRS.
The Internal Revenue Code permits ordinary and necessary business expenses that are paid or incurred in carrying on a trade or business to be deducted from the gross income of that business. Furthermore, depreciation deductions for property are generally available to a taxpayer if the property is used in a trade or business and the taxpayer is engaged in a profit-driven venture. However, the Internal Revenue Code limits deductions to the amount of income produced from an activity when that activity is deemed a hobby. Whether an entity is a hobby is a facts and circumstances determination; however, activities involving elements of personal use or benefit tend to be more susceptible to classification as a hobby by the IRS.
In analyzing whether an activity is subject to these hobby loss rules, the IRS tends to argue that each entity is separate and distinct for state law liability purposes. Therefore, under the IRS interpretation, each entity in a business structure should be treated as legally separate for U.S. income tax purposes in determining whether an entity’s activities are subject to disallowance under a number of Internal Revenue Code sections that operate to disallow losses, including the hobby loss rules at issue in Morton. This approach, if upheld, generally prohibits related entities that are potentially subject to a disallowance provision, such as the hobby loss disallowance provision, from using the activities of other more active businesses to avoid the hobby loss expense disallowance rules.
Peter Morton utilized multiple entities to segregate separate lines of business and to limit liability exposure by using several entities to fund, market, and manage the Hard Rock brand. RWB was one of Morton’s entities and served as the transportation division of Morton’s business empire. RWB purchased and maintained a Gulfstream III plane. The Gulfstream III plane was used for both business and personal purposes. RWB generated extensive business expenses and depreciation deductions greater in value than the income it generated, resulting in a significant overall tax loss. Morton deducted this loss against taxable income that was generated by his other profitable entities as a means to lower his U.S. income tax liability. Morton argued that the economic reality of the situation indicated that all of his businesses, regardless of their legally separate entity status, were unified in their common goal of promoting and expanding the Hard Rock brand. Subsequently, the IRS audited Morton and disallowed netting RWB’s tax loss as a hobby loss against the taxable income from other separate entities in the Morton business structure. Morton paid the claimed taxes owed and subsequently filed suit in the Court of Federal Claims seeking a tax refund of nearly $9.8 million.
The Court of Federal Claims rejected the IRS’s argument that legally separate entities must be considered separate and distinct in analyzing whether the activities in one entity of a business enterprise are deemed a hobby. The Court held that the entire economic relationship is what determines the appropriate economic unit. The activities of the appropriate economic unit, and not a single business division, drive the associated U.S. income tax liability consequences of the economic unit. The Court stated that it matters not if Morton had titled the plane in his own name or in RWB’s, the U.S. tax consequences remain the same when all entities are essentially one economic unit.
The Court held that the entities’ common goal was operating and maintaining the Hard Rock Brand and all of the entities used in his business ventures were appropriately grouped as one economic unit for U.S. tax purposes. Morton allows several legally distinct entities with a common profit motive to be viewed as a unified business enterprise for U.S. tax purposes, while still maintaining the benefits of asset protection available under a jurisdiction’s laws.
Under Morton, taxpayers may now be entitled to net otherwise unusable losses of one entity with the taxable profits of another. The Court of Federal Claim’s decision only reviewed and ultimately accepted the unified business enterprise theory in the context of the hobby loss rules. However, the Morton decision did not limit the application of the unified business enterprise theory to the hobby loss rules. Accordingly, the unified business enterprise theory may be applicable to other loss disallowance provisions of the Internal Revenue Code.
We would welcome the opportunity to discuss how to optimize your business affairs in light of Morton and review your business structure in prior years for any refund opportunities as a result of Morton.
PURSUANT TO REQUIREMENTS RELATED TO PRACTICE BEFORE THE INTERNAL REVENUE SERVICE, ANY TAX ADVICE CONTAINED IN THIS COMMUNICATION IS NOT INTENDED TO BE USED AND CANNOT BE USED, FOR PURPOSES OF (I) AVOIDING PENALTIES IMPOSED UNDER THE UNITED STATES INTERNAL REVENUE CODE OR (II) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PERSON ANY TAX RELATED MATTER.
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