Portland Golf Club v. Commissioner of Internal Revenue/Concurrence Kennedy

by Anthony Kennedy

Justice KENNEDY, with whom Justice O'CONNOR and Justice SCALIA join, concurring in part and concurring in the judgment.

The Tax Court found that Portland Golf Club's nonmember activity qualified as a trade or business under § 162(a) of the Internal Revenue Code of 1954, 26 U.S.C. § 162(a), and it allowed the club to deduct expenses associated with the activity from its income. 55 TCM 212 (1988), ¶ 88,076 P-H Memo TC. The Court of Appeals remanded because it found the club's profit motive unclear. App. to Pet. for Cert. 1a. judgt. order reported at 876 F.2d 897 (1989). Although the Tax Court had determined that the club intended the gross receipts from the nonmember activity to exceed the direct costs, the Court of Appeals held that § 162(a) requires an intent to produce gains in excess of both direct and indirect costs. The Court of Appeals remanded the case to allow the Tax Court to reconsider the club's profit motive, taking account of the overhead and other fixed costs attributable to the nonmember activity. I agree with that decision, and so would affirm the Court of Appeals.

I join all but Parts III-B and IV of the Court's opinion. I otherwise concur only in the judgment because the Court decides a significant issue that is unnecessary to our disposition of the case and, in my view, decides it the wrong way. When the Court of Appeals instructed the Tax Court to consider the club's indirect costs, it did not specify how the club should allocate these costs between its member and nonmember activities. In particular, it left open the possibility that the club could use one allocation method to calculate its expenses under § 162(a), while using some other allocation method to demonstrate its profit motivation. See ante, at 167-168. Although the Court purports to affirm the Court of Appeals, its opinion eliminates this possibility, and thus works a dramatic change in the remand order. The Court rules in Parts III-B and IV that, if the club uses the so-called gross-to-gross method to allocate its fixed costs when computing its expenses, it must use the same allocation method to prove its profit motivation. The Tax Court and Court of Appeals, in my view, should have had the opportunity to consider this issue in the first instance. Because the Court has reached the question, however, I must state my disagreement with its conclusion.

A taxpayer's profit motive, in my view, cannot turn upon the particular accounting method by which it reports its ordinary and necessary expenses to the Internal Revenue Service (IRS). The Court cites no authority for its novel rule and we cannot adopt it simply because we confront a hard case. Section 162(a) provides: "There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. . . ." 26 U.S.C. § 162(a). Although the section does not require a profit motivation by its express terms, we have inferred such a requirement because the words "trade or business," in their ordinary usage, contemplate activities undertaken to earn a profit. See Commissioner v. Groetzinger, 480 U.S. 23, 27-28, 107 S.Ct. 980, 983-984, 94 L.Ed.2d 25 (1987); Flint v. Stone Tracy Co., 220 U.S. 107, 171, 31 S.Ct. 342, 357, 55 L.Ed. 389 (1911). Yet, I see no justification for making the profit-motive requirement more demanding than necessary to distinguish trades and businesses from other activities pursued by taxpayers. See Whipple v. Commissioner, 373 U.S. 193, 197, 83 S.Ct. 1168, 1171, 10 L.Ed.2d 288 (1963). Because an activity may be a trade or business even if the taxpayer intended to show losses on its income tax forms under a permissible accounting method, the Court endorses an improper conception of profit motivation.

A taxpayer often may choose from among different accounting methods when computing its ordinary and necessary expenses under § 162(a). In this case, as stipulated by the IRS, the club could have allocated its fixed costs either by the gross-to-gross method or by the so-called actual-use method. Although the gross-to-gross method showed a net loss for the relevant tax years, the actual-use method would have shown a net profit. See ante, at 158, n. 5. If profit motivation turns upon the allocation method employed by the club in filling out its tax forms, then the status of the nonmember activity as a trade or business may lie within the control of the club's accountants. I find this interpretation of the words "trade or business" simply "to affront common understanding and to deny the facts of common experience." Helvering v. Horst, 311 U.S. 112, 118, 61 S.Ct. 144, 147, 85 L.Ed. 75 (1940). A taxpayer does not alter the nature of an enterprise by selecting one reasonable allocation method over another.

The Court's decision also departs from the traditional practice of the courts and the IRS. Rather than relying on strict consistency in accounting, the courts long have evaluated profit motivation according to a variety of factors that indicate whether the taxpayer acted in a manner characteristic of one engaged in a trade or business. See, e.g., Teitelbaum v. C.I.R., 294 F.2d 541, 545 (CA7 1961); Patterson v. United States, 459 F.2d 487, 493-494, 198 Ct.Cl. 543, 552-553, (1972); see Boyle, What is a Trade or Business?, 39 Tax Law. 737, 743-745 (1986); Lee, A Blend of Old Wines in a New Wineskin: Section 183 and Beyond, 29 Tax L.Rev. 347, 390-447 (1974). In a regulation based on a wide range of prior court decisions, the IRS itself has explained § 162 and profit motivation as follows:

"Deductions are allowable under section 162 for expenses of carrying on activities which constitute a trade or business of the taxpayer and under section 212 for expenses incurred in connection with activities engaged in for the production or collection of income or for the management, conservation, or maintenance of property held for the production of income. Except as provided in section 183 and [26 CFR] § 1.183-1 [which authorize individuals and S-corporations to offset hobby losses], no deductions are allowable for expenses incurred in connection with activities which are not engaged in for profit. . . . The determination whether an activity is engaged in for profit is to be made by reference to objective standards, taking into account all of the facts and circumstances of each case. Although a reasonable expectation of profit is not required, the facts and circumstances must indicate that the taxpayer entered into the activity, or continued the activity, with the objective of making a profit." 26 CFR § 1.183-2(a) (1989).

To facilitate the application of this general standard, the IRS has supplied a list of nine factors, also based on a wide body of case law, for evaluating the taxpayer's profit motive. These factors include: (1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his advisors; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer's history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, which are earned; (8) the financial status of the taxpayer; and (9) the elements of personal pleasure or recreation. See §§ 1.183-2(b)(1) to (9).

The Court today limits this longstanding approach by pinning the profit-motive requirement to the accounting method that a taxpayer uses to report its ordinary and necessary expenses under § 162(a). Although the tax laws in general strive to reflect the true economic income of a taxpayer, the IRS at times allows taxpayers to use accounting methods that understate their income or overstate their expenses. In this case, as the Court itself acknowledges, the IRS stipulated that the club could use the gross-to-gross allocation method to calculate its expenses under § 162(a) even though this method tends to exaggerate the percentage of fixed costs attributable to the club's nonmember sales. See ante, at 157-158, n. 4. Yet, I see no basis for saying that, when the club took advantage of this unconditional stipulation, it committed itself to the legal position that the gross-to-gross method best reflects economic reality. Some inconsistency will exist if the club uses the gross-to-gross allocation method in computing the expenses, while using some other reasonable accounting method to prove that it undertook the nonmember activity as a trade or business. But the solution to this inconsistency lies in altering the stipulation in other cases, not in changing the longstanding interpretation of profit motivation.

The precise effect of the Court's holding with respect to the club remains unclear. The Court states only that the club may not offset its losses from nonmember sales against its investment income. But I do not understand how the Court can confine its ruling to investment income alone. If the club's nonmember activity does not qualify as a trade or business, then the club cannot use § 162(a) to deduct any of the expenses associated with the nonmember activity, not even to the extent of gross receipts. Confronted with this difficulty at oral argument, respondent stated that, in the absence of statutory authority, the IRS has allowed an offset of expenses against gross receipts out of its own "generosity," a characteristic as rare as it is implausible. Tr. of Oral Arg. 42-43. The IRS, indeed, asserts the authority to disallow the offset in the future. See id., at 44. Cf. 26 U.S.C. § 183 (authorizing individuals and S-corporations to offset hobby losses). This possibility further counsels against making the profit-motive requirement more stringent than necessary to determine whether the club undertook the nonmember activity as a trade or business. For these reasons, I join the Court's opinion, with the exception of Parts III-B and IV, and concur in the judgment.

Notes