The Profit Motive Requirement as it Relates to Tax Shelter Investments

• Publication year: 1986
• Pages: 786
• Citation: Vol. 15 No. 5 Pg. 786

15 Colo.Law. 786 Colorado Lawyer 1986.

1986, May, Pg. 786. The Profit Motive Requirement as it Relates to Tax Shelter Investments

---

786

Vol. 15, No. 5, Pg. 786

The Profit Motive Requirement as it Relates to Tax Shelter Investments

by John L. Ruppert and Terrance L. Bessey

The courts have relied heavily in recent years on the absence of a "profit motive" to disallow deductions and credits claimed by investors in abusive tax shelters. Investors in a tax shelter must be able to demonstrate a profit motive for their investments to sustain, if challenged, their share of depreciation deductions, investment tax credits and deductions for operating expenses. Investors also must be able to demonstrate a business reason (which means a pre-tax, economic motive) for any tax shelter-related borrowings to be able to deduct interest attributable to such borrowings.(fn1)

This article discusses the following issues with respect to the profit motive test: (1) how profit is calculated; (2) when to test for the profit motive; (3) how much profit is required; (4) what the relationship is, if any, between a taxpayer's profit and tax savings motives; and (5) the types of tax shelter situations for which the Internal Revenue Service ("IRS") is most likely to raise the profit motive argument.

Profit Motive and Code § 183

Before turning to these issues, § 183 of the Internal Revenue Code of 1954, as amended ("Code") should be discussed. This is the statutory profit motive safe harbor, and a discussion of its relationship to the judicially created profit motive test is in order.

Code § 183 limits the deductions allowable to individuals, partnerships(fn2) and S corporations with respect to an activity not engaged in for profit to the sum of (1) those deductions allowable without regard to whether the activity is engaged in for profit, plus (2) those deductions which would be allowable if the activity were engaged in for profit, but only to the extent that gross income from the activity exceeds the deductions described in (1).

Treas. Reg. § 1.183-2(a) states that the determination of whether an activity is engaged in for profit should be made by reference to objective standards, taking into account all the relevant facts and circumstances. The Treas. Reg. also states that a reasonable expectation of profit is not required; however, taxpayers must demonstrate that they entered into, or continued, the activity with a profit objective.

Treas. Reg. § 1.183-2(b) identifies the following nine factors as reflective of a profit motive:

1) operation of the investment in a businesslike manner;

2) study of the business and economic practices in the industry or consultation with experts therein;

3) devotion of a substantial amount of the taxpayer's time to the activity;

4) expectation that the activity's assets may appreciate in value;

5) profitable conduct of similar activities in the past;

6) operating profit after the start-up phase;

7) in the absence of operating profit, substantial profit on an occasional basis where the investment or losses are comparatively small or the investment is speculative;

8) no substantial income or capital from other sources; and

9) absence of purely personal or recreational motives for the activity.

These factors are nonexclusive, and no one factor (or combination of factors) is determinative of the presence or absence of a profit motive

The courts have used these nine factors as a starting point in testing for the presence or absence of profit motive in tax shelter transactions. However, many of these factors are not applicable to tax shelter activities conducted in limited partnership, S corporation or trust form. As a result, the courts have looked to all the facts and circumstances of each investment and have identified several other factors (see below) which are specifically applicable to tax shelter investments.(fn3)

How Profit is Calculated

There are four basic ways to analyze the profit potential of a tax shelter investment: (1) cash-on-cash return; (2) net present value; (3) compound net present value; and (4) internal rate of return.(fn4)

The cash-on-cash return method is the simplest method of analysis. It compares the taxpayer's cash investment with the cash flow and gross tax savings from the investment. A transaction has economic motivation under this method if the sum of the cash received and gross tax savings exceed the total cash investment. The major flaw with this method is that it ignores the time value of money.

The net present value method discounts all cash flows (both positive and negative) and tax savings back to present value at an assumed discount rate. While this method takes into account the time value of money, it is only as accurate as the assumed discount rate, which is very difficult to predict.

The compound net present value method eliminates the problem of having to predict the discount rate, which is inherent in the net present value method. The compound net method looks to the compound interest rate which will cause the investment cost to equal the total future values of the net benefits over the life of the investment.

The last method, internal...