In connection with promoting his law practice, Avery deducted for income tax purposes expenditures he incurred to support his activity as a racing car driver. Avery characterized the expenditures as advertising expenses related to promoting his law practice. IRS disallowed the expenses as not ordinary and necessary to Avery’s practice as a personal injury lawyer. James W. Avery, TC Memo 2023-18 (“James W. Avery”), on appeal 10th Circuit of Appeals (No. 23-9004).
Let’s step back a moment and take a quick look at the global Motorsports Industry. Apparently, a huge multi-billion-dollar industry that encompasses the many facets of motor sports, including, for example, the racing of Formula 1, Touring, Sports and Stock car automobiles. Avery engaged in stock car racing. Two income tax-specific questions are 1) whether the racing activity expenses were incurred in connection with a trade or business and 2) whether the racing activity itself constituted a trade or business.
Mise en Scene
IRS filed tax liens against Avery’s property and held a collection due process (“CDP”) hearing. IRS claimed that it had sent statutory notices of deficiencies (90-day letters) for the years 2008 through 2013 to Avery’s last known address. Based on the premise that Avery had the opportunity to contest the underlying tax liabilities in the Tax Court, the IRS settlement officers would not consider either Avery’s challenges to the underlying tax liabilities or his proposed offer in compromise. Avery then petitioned the Tax Court. Upon an IRS’ determination in a CDP matter, the taxpayer has 30 days to petition the Tax Court. See Internal Revenue Code section 6330(d).
Generally, taxpayers are only allowed one bite at the apple. Taxpayers have the right to contest federal tax liabilities but need to follow applicable procedural rules. The Internal Revenue Code provides that the underlying tax liabilities may not be contested in the CDP hearing except in the case where the taxpayer did not receivethe statutory notices of deficiency regarding such liabilities or otherwise was not afforded the opportunity to dispute the liabilities. See section 6330 (c)(2)(B).
The Tax Court decided to review Avery’s claims on the merits. The IRS conceded that Avery had not received the notices of deficiency, although it had sent the notices to Avery’s last known address via certified mail. The Tax Court (Judge Lauber) considered Avery’s claims regarding the underlying liabilities, and more specifically, Avery’s arguments in support of the deductibility of the auto racing expenses that Avery was able to substantiate.
At the end of the Tax Court trial, the court directed the IRS and Avery to each file a post-trial brief. Curiously, Avery failed to file his brief. The court in a footnote stated that although it could enter a decision against Avery because he neglected to follow the judge’s direction pursuant to the court’s Rule 123(b), it would consider the deductibility issue on the merits.
Racing Activities
Avery carried on his law practice in Denver, Colorado, including meeting with his clients. He engaged in auto racing activities in Indiana and other places in the Midwest, and on the East Coast. The court reported that it did not find “synergy” between Denver and any of the racing venues. In other words, there appeared to be no meaningful connection between Avery’s law practice in Denver and his racing activities in the Midwest and on the East Coast.
There were no billboards or newspaper ads promoting Avery’s law practice. Avery did have his name and name of his law firm in small print on a decal located at the rear of the Dodge Viper, his racing car. The court noted that it is typical of drivers to have their names on their racing cars.
Avery contended that his auto racing activities promoted his law practice. For example, his racing activities provided a good conversation starter when he met with potential referral sources, namely, lawyers, doctors and other professionals. Unfortunately, Avery was unable to provide an example of his obtaining a personal injury matter due to his racing activities, although he apparently did receive a consultation matter involving a vendor dispute. In effect, and cutting to the chase, the court was not convinced that Avery’s racing activities were anything more than a hobby.
According to the Tax Court, “[i]n determining whether an expense is ‘ordinary and necessary’ within the meaning of section 162(a), the courts have focused on the tax-payer’s primary motive for incurring the expense and on whether there is a reasonably proximate relationship between the expense and the taxpayer’s occupation. (Citations omitted.) If an expenditure is primarily motivated by personal considerations, no deduction is allowed. (Citations omitted.)”
The court agreed with the IRS that Avery’s “racing-related costs were not ordinary and necessary expenses of his business as an attorney. It is neither ‘necessary’ nor ‘common’ for attorneys to incur such costs. [Avery] greatly enjoyed car racing, which he found more exciting than his previous hobby of acquiring collector cars and participating in car shows. But we find that both activities were hobbies. No deduction is allowed for personal expenses of this kind. See § 262(a) (disallowing deductions for ‘personal, living, or family expenses’).”
The court examined prior cases. “This case is distinguishable from prior cases – e.g., involving car dealerships, construction companies, and companies engaged in the sale and leasing of aircraft – in which we found car or motorcycle racing expenses to be deductible advertising costs. (Citations omitted.) In several of these cases, the fact that unrelated sponsors compensated the driver for displaying their logos confirmed the seriousness of the racing activity. (Citations omitted.) In each of those cases we found as a fact that there existed ‘a proximate relationship between the expenditure and the business of the taxpayer.’ (Citations omitted.) [Avery] has not carried his burden of proving any such ‘proximate relationship’ here. And the evidence conclusively showed that he engaged in car racing primarily for personal enjoyment, not to advertise his legal services.”
In a similar vein, the Tax Court (Judge Marvel) in Berry v Commissioner, T.C. Memo 2021-42, denied an S corporation’s deductions for automobile racing expenses incurred in support of the racing activities of the owner’s son (who also owned some of the S corporation’s shares) since the court did not find the needed connection of such expenses to the promotion of the corporation’s real estate development and construction business.
Although not classified as such on the corporation’s income tax return, petitioners (the S corporation’s shareholders) argued that such expenses were advertising expenses incurred to promote the corporation’s real estate development and construction business. Alternatively, the petitioners in Berry argued that the racing activity itself was a trade or business. However, based on the circumstances that there was no racing activity or income earned in the taxable year before the court, the court dismissed the alternative argument as “ill-conceived.”
Unlike Berry, Avery did not take the bait, i.e., that his auto racing activity itself constituted a trade or business. In appropriate cases, of course, such an argument is not far-fetched. For example, the existence of a trade or business is easily demonstrable by professional racing car drivers, whether operating as sole proprietorships or as employees of their self-owned business entities.
On its merits, the Tax Court in James W. Avery denied the deductibility of the auto racing expenses since it did not find the needed connection between the law practice and the racing activities. The court did remand the case to the IRS to consider Avery’s offer in compromise. TC Memo 2023-18.
This saga may not be over. Avery has appealed to the Tenth Circuit. No. 23-9004.
Reprinted with permission from the New York Law Journal, An ALM Publication