Tax Implications of Yacht Charter Operations By Nick G. Tarlson, CPA, MST (Taxation)

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1 Tax Implications of Yacht Charter Operations By Nick G. Tarlson, CPA, MST (Taxation) As a yacht owner and charter business operator, you will be subject to a number of tax rules. It is important that you plan and operate your business so that it qualifies for the tax treatment which you expect. Requirements of a Yacht Charter Business Under the tax laws, a business activity is an activity that is entered into profit. In establishing whether an activity is a trade or business, the IRS will evaluate nine factors. 1. Business Approach. The business should be operated in a businesslike manner. 1 a. Planning. You should investigate the business opportunity thoroughly 2, document each step of the process, including all of your efforts to research and plan the business, and prepare a professional business plan with written financial projections documenting your plan to make a profit. 3 b. Recordkeeping. Maintain a record (diary or log) of any trips you made to investigate chartering opportunities, meetings with boat brokers, charter company representatives, business advisors, accountants, and maintenance personnel. Record the dates, names, addresses, and details of events and business discussions concerning the charter business. You will want to show that you studied accepted business practices, consulted with experts, and devoted time and effort to the business plan. Establish a solid accounting system, engine log, and records of charter activity. 4 Keep copies of your charter contracts, deposit records, paid invoices, maintenance work orders, and all other documentation required to support your accounting system and demonstrate that you are operating in a businesslike manner. 1 Reg. Sec (b)(1). In the case law, the courts define a profit as taxable income, so it is not sufficient to have an after tax income or cash flow. There are, however, regulations and case law which indicate that the courts will consider the resale value of the resale equipment in determining whether there is a profit motive. 2 Hellings v. Commr., TC Memo Heppee v. Commr., TC Memo McLarney v. Commr., TC Memo

2 c. Separate Accounts. Utilize a separate checking account for the activity, 5 and prepare periodic (monthly or quarterly) summaries of actual compared with budgeted results. You may want to form a separate business entity or a fictitious business name for the activity. d. Financial Reporting and Analysis. Determine the reasons for any differences between actual and projected amounts, and document your conclusions and what corrective action, if any, was taken by management. A long history of losses, with no substantial operational changes, has been interpreted as evidence of an absence of profit motive by the Tax Court, while actions to improve performance are viewed as businesslike and profit-oriented. 6 e. Advertising and Promotion. You should also devote some effort and expense to advertising and promoting the business, even if it is managed by an agency. The IRS will consider whether you made expenditures commensurate with your anticipation of profit. 7 It is also helpful to consider unique and unusual arrangements with your charter agency, such as incentive provisions for improved performance Expertise of Taxpayer or Advisors. Prepare for the activity by extensive study and consultation with experts. The study should include accepted business, economic and scientific practices. Operate the business in accordance with the accepted practices, unless you are intentionally attempting to develop new or superior techniques, in order to show that you have a profit motive. Changing your business approach based on evidence of better approaches can also show that you have a profit motive. 3. Time and Effort. You should devote a significant amount of time to the activity, or employ competent and qualified persons to carry on the activity on your behalf (but, see the passive activity rules, below). You should document the agent s expertise as well as the advantages of employing the agent, such as proximity to your home. 4. Potential Appreciation. An expectation that the property may increase in value can be considered as part of the profit motive. Although you do not normally think of a yacht as an investment, in today s depressed market you might be acquiring your yacht for substantially less than its original asking price. Document your purchase in comparison to prices of comparable vessels if you feel you can argue that investment appreciation will be part of your profit motive. 5. Taxpayer s Business Experience. Success in carrying on other similar or dissimilar activities may indicate that you are engaged in this business for profit. If you are engaged 5 Kahle v. Commr., TC Memo Swigert v. Commr., TC Memo Zwicky v. Commr. TC Memo Dickson v. Commr., TC Memo , Kahle v. Commr., TC Memo , Feldman v. Commr. TC Memo

3 in other investment activities, such as real estate or equipment rental, document the similarities and differences, and how you considered these in making the decision to engage in this business. 6. History of Income or Losses. Your history of income or losses with respect to the activity could indicate whether or not you have a profit motive. Startup losses are to be expected, but continued losses could be viewed as a sign you are not engaged in the business for profit. Comparisons to your business plan and efforts to correct problems could be taken as evidence that you are engaged in the business for profit. Losses due to circumstances outside your control, such as storms, can be used to explain losses. 9 A downturn in the charter boat industry could be seen as outside your control Occasional Profits. The amount of occasional profits are indicative of whether the activity is engaged in for profit. The magnitude of the profits, in comparison with any losses, is important. An occasional small profit from an activity generating large losses, may indicate the activity is not engaged in for profit. 8. Taxpayer s Financial Status. The financial status of the taxpayer may be considered. The availability of substantial income from other sources, along with personal or recreational interest in the activity, could indicate an activity is not engaged in for profit. IRS and court reliance on this factor is less than the others. 9. Personal Pleasure or Recreation. Elements of personal pleasure or recreation may indicate an activity is not engaged in for profit, but a personal interest in an activity doesn t necessarily mean it is not engaged in for profit. Selection of a management agency near your home and high level of personal involvement have been found to support a profit motive. 11 Knowledge and experience in yachting and boats has been found to support a profit motive. 12 Other Ways to Characterize Yacht Charter Activities Not all yacht charter activities are operated as for profit businesses. Those with certain characteristics could be characterized as any of the following types of activities, with significantly different tax consequences. 1. Hobby. 2. Rental activity. 3. Passive activity. 4. Entertainment facility. 5. Vacation home. 9 Jackson v. Commr., 59 TC 312 (1972). 10 Dickson v. Commr., op. cit. 11 Feldman v. Commr., op. cit. 12 Kahle v. Commr., op. cit. 3

4 Hobbies A hobby is an activity which is not engaged in for profit. Under the Hobby Loss Rule of Section 183(d), you are presumed to be engaged in a for-profit business rather than a hobby if you have profit in three of the last five years. If you are lucky enough to meet this test, you should have little difficulty establishing that the yacht charter activity is a business, and not a hobby. If you think you will meet the Hobby Loss Presumption, you can make an election which prevents the IRS from making a determination as to whether or not you are engaged in a business until the end of the fourth tax year. But such an election holds each tax year open under the statute of limitations until two years after the close of the fifth tax year. That could be a very bad thing if an earlier year would have ordinarily closed under the statute of limitations, which is normally only three years after the tax return is filed. The IRS likes to turn the Hobby Loss Presumption around, and allege that losses over several years suggest that you are engaged in a hobby, rather than a business. Don t let them get away with such an argument. Remind them that the bottom line is whether the intent is to make a profit, not whether or not there is actually a profit. Point to other evidence under the nine-factor test which supports the characterization of your activity as a business. Rental Activities A trade or business activity does not include a rental activity or the rental of property that is incidental to an activity of holding the property for investment. The rental activity prohibition is closely related to the passive activity rules. A rental activity is a passive activity even if you materially participated in that activity, unless you materially participated as a real estate professional. An activity is a rental activity if tangible property (real or personal) is used by customers or held for use by customers, and the gross income (or expected gross income) from the activity represents amounts paid (or to be paid) mainly for the use of the property. It does not matter whether the use is under a lease, a service contract, or some other arrangement. Your activity is not a rental activity if : The average period of customer use of the property is 7 days or less, or The average period of customer use of the property, as figured in (1) above, is 30 days or less and you provide significant personal services with the rentals. 13 Entertainment Facilities You cannot deduct the cost of acquiring or maintaining a yacht for the purpose of entertaining clients or customers. However, you or your employer may be able to deduct the cost of chartering a yacht for team-building and related business purposes. 13 Reg T(e)(3)(ii). 4

5 Vacation Home Your yacht may be considered to be a dwelling unit under IRS rules. 14 If you use the yacht for personal use more than 14 days a year, or 10 percent of the days it is rented, whichever is greater, it is considered to be used as a home. If this is the case, your deductible rental expenses are limited to your rental income and you cannot use the excess expenses to offset income from other sources. The excess can be carried forward to the next year and treated as rental expenses for the same property. Any expenses carried forward to the next year will be subject to any limits that apply for that year. You can deduct the expenses carried over to a year only up to the amount of your rental income for that year, even if you do not use the property as your home for that year. Personal use includes use by any member of any family of a person that has an interest in the yacht, 15 use of the yacht by someone in exchange for use of another property (like a time share), donations of the use of the yacht to a charitable organization if sold at a fundraising event and used by the purchaser of the donation, and any use of the property at less than a fair rental price. Whether or not you meet the 14 day or 10 percent test, and even if your yacht is operated as a business as described above, if you use the yacht for both rental and personal purposes, you must divide your expenses between the rental use and the personal use based on the number of days used for each purpose, and only the rental expenses are deductible. Any day that the unit is rented at a fair rental price is a day of rental use even if you used the unit for personal purposes that day. (This rule does not apply when determining whether you used the unit as a home.) Days Used for Repairs and Maintenance Any day that you spend working substantially full time repairing and maintaining your property is not counted as a day of personal use, even if family members use the property for recreational purposes on the same day. Passive Activities The passive activity rules are intended to prevent you from deducting losses from an activity in which you are not involved on a regular, continuous and substantial basis. If your business is characterized as a passive activity, your deductions will be suspended until you realize profits or dispose of the business. A trade or business activities in which you materially participated for the tax year is not a passive activity. You are considered to have materially participated if: You participated in the activity for more than 500 hours, Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity, You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year, 14 Publication 527, Residential Rental Property. 15 Unless used by the family member as their main home for payment of fair rental price. 5

6 You materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years, or Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year. Participation In general, any work you do in connection with an activity in which you own an interest is treated as participation in the activity, with just a couple of important exceptions.. Work not usually performed by owners You do not treat the work you do in connection with an activity as participation in the activity if both of the following are true. The work is not work that is customarily done by the owner of that type of activity. One of your main reasons for doing the work is to avoid the disallowance of any loss or credit from the activity under the passive activity rules. Participation as an investor You do not treat the work you do in your capacity as an investor in an activity as participation unless you are directly involved in the day-to-day management or operations of the activity. Work you do as an investor includes: Studying and reviewing financial statements or reports on operations of the activity, Preparing or compiling summaries or analyses of the finances or operations of the activity for your own use, and Monitoring the finances or operations of the activity in a non-managerial capacity. Note that you could prepare and compile information in your capacity as a manager of the business, as compared with that which might be used as an investor in the business, and that it could still be considered as active participation in the management of the business. Spouse's participation Your participation in an activity includes your spouse's participation. This applies even if your spouse did not own any interest in the activity and you and your spouse do not file a joint return for the year. Proof of participation You can use any reasonable method to prove your participation in an activity for the year. You do not have to keep contemporaneous daily time reports, logs, or similar documents if you can establish your participation in some other way. For example, you can show the services you performed and the approximate number of hours spent by using an appointment book, calendar, or 6

7 narrative summary. The better your records, the better your chances of substantiating your participation. For more information, see Publication 925 Passive Activity and At-Risk Rules. Pass Through Entities The determination of whether an activity is a trade or business is made at the entity level. The material participation and passive activity rules are applied at the individual level. Section 179 deductions are limited to business income of the entity, so if you are planning to offset individual business income, you should avoid some pass through entities during the year of acquisition. Depreciation If your vessel is used predominantly, i.e., more than 50 percent of the total use, for qualified (i.e., non-rental) business use, you can depreciate it using the Modified Accelerated Cost Recovery System (MACRS) for asset class 00.28, vessels, barges, tugs and similar water transportation equipment, using a ten year service life and 200 percent or 150 percent declining balance or straight line methods. Before you decide on the appropriate depreciation service life and method, you should review the provisions relating to recapture and alternative minimum tax, below. The depreciable cost basis is the cost basis times the percentage of business use. Cost basis is the lesser of the original cost or market value when dedicated to business use. Section 179 The Section 179 Deduction allows you to deduct a fixed dollar amount in the first year in which business property is placed in service. The Section 179 Deduction is $25,000 for 2014 and beyond. The limitations apply at both the individual and entity levels. Losses resulting from the deduction can offset income from other business income, including wage income 16, but not non-business income such as retirement benefits. Before you decide on the appropriate Section 179 deduction, you should review the provisions relating to recapture, below. 16 Reg. Sec Limitations on amount subject to section 179 election provides: (c) Taxable income limitation--(1) In general. The aggregate cost of section 179 property elected to be expensed under section 179 that may be deducted for any taxable year may not exceed the aggregate amount of taxable income of the taxpayer for such taxable year that is derived from the active conduct by the taxpayer of any trade or business during the taxable year (6) Active conduct by the taxpayer of a trade or business (iv) Employees. For purposes of this section, employees are considered to be engaged in the active conduct of the trade or business of their employment. Thus, wages, salaries, tips, and other compensation (not reduced by unreimbursed employee business expenses) derived by a taxpayer as an employee are included in the aggregate amount of taxable income of the taxpayer under paragraph (c)(1) of this section. 7

8 Recapture Depreciation and Section 179 deductions are recaptured as ordinary income when the property is transferred, or when it no longer meets the predominant use test. The recapture amount is based on the difference between the actual deductions and those which would otherwise be available on a straight-line basis. If the property is transferred while it is still being used as predominant use property, the ten year life would apply. But if the property is converted to non-predominant use property, the applicable recovery period would be 18 years, so there would be recapture of any amounts taken in excess of what would be allowed under 18 year straight line depreciation. If there is any chance that you will be selling or removing the yacht from use in the charter business, you should consider the impact of recapture on your income taxes during that future year. It may be possible to avoid recapture by transferring the property to another entity, such as a partnership or corporation, before the change in predominant use. Alternative Minimum Tax (AMT) If the 200 percent declining balance method is used for regular tax purposes, then the 150 percent declining balance method must be used for AMT purposes. 17 So you can simplify your tax accounting somewhat by using a 150 percent or less declining balance method for regular tax, as well. No AMT adjustment is required to the amount expensed under Section Income Tax Reporting As a personal (as opposed to real) property rental business, if the business is operated by you as an individual, the income from the business should be reported on Line 21, and the expense should be reported on Line 35 of Form You should not report this type of business on Schedule C or E of your tax return. If you are operating as a partnership, corporation, or LLC, you will report the income and expense as from a trade or business. California Sales and Use Tax You can either pay sales and use tax when you acquire the vessel based on its purchase price, or you can collect and pay it on your charter rental income when you charter the vessel. Your decision should consider the amount and timing of anticipated charter rental, compared with the purchase price. Tarlson & Associates Your Yacht Charter Business Resource Tarlson & Associates is an independent public accounting firm which serves a wide range of individuals, businesses, trusts, estates, and nonprofits across many industries. One of our specializations is advising charter operators on the tax implications of their activities. We can help you by evaluating the charter business opportunity, preparing financial projections, recordkeeping, and periodic financial analysis and evaluation. 17 Code Sec. 56(a)(1). 18 Code Sec. 56(a)(1)(B). 8

9 In addition to assisting with planning and managing these activities, we can assist in preparation and filing of the appropriate income, sales, and property tax returns, and in working with tax authorities who question your tax treatment of the activity. With most financial matters, the earlier we are involved, the more likely we are to be able to help you. Sound planning is often the key to success in these cases. If you receive any communications from tax authorities, you should forward any notices or other evidence of the nature of the issue and contact us immediately. 9