Auto racing is expensive at any level. Often, a racer looks to reduce the cost by treating it as a business activity to deduct the expenses.
Racers who do this have encountered mixed results when the IRS challenges their returns. If you are going to give this a try, it’s a good idea to understand how the tax rules apply, so your racing activity stands the best chance of being deductible.
Is it a business?
If you’re Tony Stewart, there isn’t much reason to read further. Stewart-Haas Racing is unquestionably a business aiming to make money — no matter how much fun Mr. Stewart has driving in races. Large amounts of sponsor fees, purses, endorsement revenue, merchandise sales, and so on demonstrate that making money is the goal, and all legitimately deductible expenses will go unchallenged.
But for the rest of us, it’s pretty hard to see how we are ever going to make any money racing. To deduct our racing expenses, we have to justify the racing as a promotional activity for some other business we own. The question becomes whether the racing activities are bona fide business promotion expenses — or just an attempt to get the government to subsidize our hobby.
Ordinary and necessary expenses
To be deductible, auto racing expenses must be “ordinary and necessary” to the operation of the related business. But, as in many tax situations, ordinary words do not always carry their ordinary meanings.
The Tax Court routinely interprets “ordinary” to mean only that the expense has a reasonably proximate relation to the operation of the business. It does not have to be something that is common among similar businesses. “Necessary” has been interpreted to mean only that the expense is helpful and appropriate in promoting and maintaining the business. It does not have to be essential — or the only way that an objective might be achieved. Both definitions are helpful.
One of the leading Tax Court cases is The Lang Chevrolet Company (1967), in which a Chevrolet dealer deducted the cost of racing Corvettes driven by the owner’s son Richard.
Lang Chevrolet engaged in auto racing to demonstrate the abilities of its personnel. The court saw that the dealership’s ability to modify a car into a national champion race car would give customers the confidence that the dealership had plenty of skill and knowledge to service their street cars.
This was communicated through the trophies displayed at the dealership and through media publicity that the racing generated. Racing also gave Lang Chevrolet a bit of a marketing “gimmick” that set it apart from its competition.
The IRS cried foul, saying that Lang raced because he enjoyed it. The court didn’t care, stating, “Surely Richard must have enjoyed something about racing or else he would not have risked his life every time he took a Corvette on the track.” The court added that no case had disallowed a business deduction only because the employee derived some pleasure from his work.
The IRS also argued that the company would never have raced had the driver not been the owner’s son. The court didn’t buy that either, noting that Richard had driving skill, it was cheaper to use him than an unrelated employee, and that “a Lang driving a Chevrolet easily and logically connects racing with the Lang dealerships.”
But car dealers don’t get a free pass. In another case, a car dealer’s racing was found not to be proximately related to his auto dealership business, as it did not substitute for other advertising and the costs of racing exceeded the dealership’s total advertising budget.
You don’t have to have an automobile-related business to write off your racing. Another important case involved a company that designed and manufactured stencils used for quilts, arts and crafts, and clothing. The court saw great benefit from the taxpayer’s use of photographs of his race cars at trade shows where quilting products were displayed. They caught people’s eyes and gave the sales people something to talk about with potential customers.
Another case involved a metal-building constructor who made “several contacts” at the races and received “at least two contracts” from his racing activities. The actual business results justified the deductions.
Our firm recently successfully defended an audit involving a criminal defense lawyer’s racing activities. The business purpose was that the racing bolstered the lawyer’s image among race participants and his other clients.
Here is how we sold that to the IRS:
“Perry” is a very successful criminal defense attorney. He races regularly and hard, and he wins often. He has impressed and become acquainted with his fellow racers, and he has generated actual business from them. We identified a number of actual cases on a no-name basis — drunken driving, marijuana growing, felony fraud — that involved racers or their families. That made Perry’s case similar to the metal-building constructor case.
I took the auditor to Perry’s office and showed him how Perry had incorporated his auto racing into his lawyer “persona.” Trophies, photos and posters were all over his office, where clients couldn’t miss them. That gave them something to talk about — and helped form a personal connection with potential clients. Potential clients recognized racing as an unusual activity for a lawyer, and it created a marketing “gimmick” that set him apart from his competitors. These same results were important in Lang and the quilting company case.
The very effective marketing “gimmick” was that it was Perry who drives the cars. That was what gave people reason to talk to him at the races — and to talk with him about racing in his office. Most importantly, it was what created his personal image as a fierce competitor who hated to lose — exactly the qualities that prospective clients wanted to see in their criminal lawyer.
We stressed that criminal defense work is a young person’s game. Most clients are much younger than Perry, who is in his mid-60s. Energy and stamina is a concern for these younger clients. After all, they have to pay their legal fees up front and in full, and if their lawyer can’t cut the mustard, they don’t do very well. The racing persona gives them confidence that Perry will fight for them to the end, and that he wants to win for them.
Even if your racing expenses qualify as deductible, they must also be reasonable in amount. In application, reasonableness focuses on the relationship between the racing expenses and the gross revenues and other advertising expenditures of the business.
For example, in a case where a company operated five Round Table pizza restaurants, it was allowed to deduct its auto racing expenses up to the full amount of the 3% of gross revenues that its franchisor required it to spend on advertising — but not more.
Making your case fit
The key element is to clearly identify the connection between your racing and your business. Is it the spectators seeing your business name on the car? The impression your performance creates? The effect it has on your personal image? How else do they tie together?
Once you’ve identified the tie-in, then you need as much documentation as possible regarding the actual business benefits that you obtain from the racing. Being able to identify actual business transactions generated from racing is a big plus.
It is important to operate the racing in a business-like manner. Good records and good decision-making point to a business activity rather than a hobby.
Business signage on the car is also very helpful.
Use an S corporation
A useful technique is to form an S corporation dedicated to the racing activity. Your business would pay sponsor fees to the S corporation, which would own the car and bear all the racing expenses. The sponsor fees should be set so that the S corporation ends up with a small profit each year. This creates two advantages:
First, the sponsor fees are deducted on your business return as an advertising expense, which is what they really are. That doesn’t stand out as much as a large auto or racing expense on a law firm’s tax return, for example.
Second, the S corporation becomes engaged in a standalone racing business, which justifies its expenses. If it shows a minor profit, that is pretty low on the IRS radar screen.
Problems can arise when the S corporation shows losses every year — especially large ones. That raises the risk of challenge on the basis that the corporation is not engaged in the racing activity for purposes of generating a profit, colloquially referred to as the “hobby loss rule.” Under this rule, net income is taxable, but net losses are not deductible. You don’t have to have a profit every year, but a lengthy series of losses can attract inquiry.
Deducting your racing isn’t easy, but careful thought and planning can give you the best shot possible. ♦
JOHN DRANEAS is an attorney in Oregon. His comments are general in nature and are not intended to substitute for consultation with an attorney. He can be reached through www.draneaslaw.com.