Lawyer's Claimed Deduction for Racing Car Activities Stalls Out in Tax Court

(Parker Tax Publishing March 2023)

The Tax Court held that the IRS properly disallowed a taxpayer's deduction of advertising expenses he incurred in conducting a racing car activity which the taxpayer said promoted his business as an attorney. The court found that the expenses were not ordinary and necessary for the taxpayer's business as an attorney under Code Sec. 162(a) and the expenses were instead personal expenses for which no deduction is allowed. Avery v. Comm'r, T.C. Memo. 2023-18.

Background

James Avery is a personal injury attorney who owns his own law firm in Colorado. In 2003 he married a woman from Indiana, moved to Indiana, and became licensed to practice there. After that marriage fell apart in 2010, he moved back to Colorado. During 2008-2013 the focal point of Avery's litigation work was Denver, where he maintained his office. Although living in Indiana during 2008-2010, Avery did not generate much business there and instead was going back to Denver to try cases and meet with clients.

Avery became involved in car-related activities in 2005 after he moved to Indiana. He had no record as a lawyer in Indiana and began attending car shows, thinking this might be a way to meet potential clients. He purchased a 30-year-old Ferrari for $75,000 and another collector car. He began attending car shows as a participant, displaying his collector cars. As time went on Avery found the car shows "a little bit boring" and became interested in car racing. He purchased and rebuilt a 2000 Dodge Viper and attended a racing school in Indianapolis.

Avery began to devote an increasing amount of time to car racing. He purchased a 2009 Dodge Viper for $102,500 and this became his preferred racing vehicle. Avery's name appeared on a small area above the driver's window and the passenger window of the car. He also affixed a decal for the Avery Law Firm on the back tail of the car. Avery expressed the belief that this signage functioned as advertising for his law practice. He competed in road racing events at tracks in Indiana, Ohio, Wisconsin, Missouri, Pennsylvania, New York, Colorado, and other venues. He won local championships in the Midwestern region and at one point placed as high as Top 10 nationally. After his marriage dissolved he lacked the funds to continue racing, and from that point forward his Viper mostly sat in a garage in Denver.

Avery believed that being involved in car racing might enable him to meet lawyers, doctors, and other professionals who could help his career. But he could identify only two instances in which his car-related activity actually intersected with his law practice. Through one racing connection he met a Pizza Hut franchisee who had a dispute with a vendor. Avery subsequently "consulted" with that franchisee. Several years previously he had met a surgeon who later served as an expert witness in a personal injury case he tried in Denver. But he met that doctor at an Indiana car show, not at a racing event.

Avery failed to file returns for 2008 and 2009, and the IRS accordingly prepared substitutes for returns (SFRs). Avery's returns for those years were supposed to have been prepared by his then-wife's grandfather, a CPA. But that CPA had health problems and "got behind." Avery hired a new CPA in 2011 who, in 2013, prepared and filed delinquent returns for 2010 and 2011. On his 2012 return, Avery reported zero tax due. He did not file a return for 2013 and the IRS prepared an SFR for that year. The divorce decree, which became final in 2013, required Avery to pay his ex-wife $160,000. Avery asserted that he paid that sum using funds he had set aside to pay his past-due taxes.

The IRS determined that Avery was liable for deficiencies and late-filing and accuracy-related penalties for 2008-2013. Avery failed to pay the assessed liabilities, and the IRS issued notices of intent to levy and of a federal tax lien filing (NFTL). Avery requested a collection due process (CDP) hearing, and his case was considered by several settlement officers (SOs) during 2017 and 2018. He sought to challenge his underlying tax liabilities for all six years, contending that his correct liabilities were shown on amended returns he submitted in March 2016. The SOs verified that the notices of deficiency for 2008-2013 had been sent by certified mail to Avery's last known address. For that reason, the SOs concluded that he was prohibited from disputing his underlying tax liabilities. As a collection alternative Avery made an offer-in-compromise (OIC), proposing to compromise his outstanding liabilities for $4,277, which the SOs rejected.

The IRS later concluded that Avery should be allowed the Schedule C deductions he claimed on his delinquent and amended returns for 2008-2013, except with respect to $303,366 of racing-related costs Avery reported as advertising expenses. According to the IRS, Avery's racing-related costs were not ordinary and necessary expenses paid or incurred in carrying on his trade or business under Code Sec. 162(a). Avery took his case to the Tax Court.

Analysis

The Tax Court agreed with the IRS that Avery's racing-related costs were not ordinary and necessary expenses of his business as an attorney. Rather, the court found that Avery's car racing activities, as well as his car collecting and participation in car shows, were hobbies and the expenses were nondeductible personal expenses under Code Sec. 262(a).

The court explained that under Code Sec. 162(a), a taxpayer must show that a claimed expense was an ordinary and necessary expense of the particular business in which he was engaged. Under Deputy v. du Pont, 308 U.S. 488 (S. Ct. 1940), an expense is "ordinary" if the transaction giving rise to it is "of common or frequent occurrence in the type of business involved." Under Welch v. Helvering, 290 U.S. 111 (S. Ct. 1933), a necessary expense is one that is "appropriate and helpful" in carrying on the taxpayer's profit-seeking activity.

In the view of the Tax Court, it is neither "necessary" nor "common" for attorneys to incur car racing-related costs. The court noted that Avery greatly enjoyed car racing, which he found more exciting than his previous hobby of acquiring collector cars and participating in car shows. The court also noted that Avery's litigation practice was conducted almost exclusively in Colorado, while most of his racing activity occurred elsewhere. The court was unconvinced that Avery's racing at venues in Indiana, elsewhere in the Midwest, and on the East Coast had any synergy with his Denver-based law practice.

The court reasoned that if Avery genuinely viewed car racing as a form of advertising, one might expect that he would have ramped up this activity (or at least maintained it) when he returned in 2010 to Colorado, the main market for his legal services. But he acknowledged that his Viper mostly "sat in the garage" after he returned to Denver. The court further found that, even if Avery had raced in the relevant market, his expenses would not be legitimate advertising expenses considering that his name and a decal for his law firm appeared in relatively small print on his Viper. In addition, while Avery said he believed that being involved in car racing would enable him to meet potential clients, the court noted that he identified only one instance - involving a Pizza Hut franchisee - in which his racing activity actually intersected with his law practice. Moreover, that relationship did not lead to any personal injury litigation, but only to "consultation" about a vendor dispute. Avery also claimed that he found car racing to be a good "conversation starter" when meeting with other professionals. But the court said that possibility did not convert the costs of pursuing a hobby into deductible advertising expenses.

On the issue of penalties, the court first found that Avery had no excuse for filing his 2013 return late and that the health problems of his then-wife's grandfather did not excuse his personal, nondelegable duty to file on time. For 2010 and 2011, Avery claimed he filed late because his financial records were in the possession of his original CPA. But the court found that, since virtually all of his income consisted of receipts from his law practice, he should have had enough knowledge of what those receipts were to file a return. With regard to the failure to pay penalties, the court found that the IRS met its burden of production only for Avery's 2009 liabilities and that Avery did not have reasonable cause for failing to pay his liabilities for that year. Although Avery had to pay his ex-wife $160,000 as a result of the divorce, the court noted that he did not set aside that money until 2013, while his 2009 tax was due on April 15, 2010. The court also observed that Avery's income for 2009 was $488,185, and during that he year he evidently felt sufficiently confident in his financial position to purchase a racing car for $102,500. The court therefore concluded that Avery failed to establish that paying his 2009 tax on time would have created a risk of substantial financial loss.

On the issue of whether the SOs abused their discretion in Avery's CDP hearing, the court noted that the SOs declined to permit an underlying liability challenge and thus Avery did not have an opportunity to present collection alternatives keyed to what his actual liabilities were. The therefore remanded to the IRS Independent Office of Appeals for a supplemental hearing to consider Avery's offers of collection alternatives.

For a discussion of the rules for deducting advertising expenses, see Parker Tax ¶93,301. For a discussion of abatement of penalties due to reasonable cause, see Parker Tax ¶262,127. For a discussion of offers in compromise, see Parker Tax ¶263,165.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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