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Couple Materially Participated in Charter Boat Business; Losses Not Passive.

(Parker Tax Publishing August 25, 2015)

The taxpayers' participation in their boat charter business rose to the level of material participation for purposes of the passive activity loss rules. The fact that the taxpayers' friends and acquaintances were participants on some of their boat charters did not, per se, make those charters personal vacations or preclude them from being counted for purposes of the material participation test. Kline v. Comm'r, T.C. Memo. 2015-144.


Larry Kline was a captain at Southwest Airlines with more than 25 years of seniority. He was single in 2007 and married his wife, Christine, in 2008. Because he faced mandatory retirement from Southwest at age 60 and loved sailing, he started a boat chartering business to supplement his income later in life. Larry set up a limited liability company (LLC) which purchased two boats. He entered into an agreement with Horizon Charters to manage the boats.

One of the boats had 27 term charters in 2007 and 28 in 2008. The other had up to 10 term charters in 2008. Most of these were bareboat charters, but arrangements could be made through Horizon for provisions and a skipper if necessary. Larry chartered one of the boats twice in 2007 and twice in 2008, accounting for two of the term charters in each year. The average period of customer use for each boat during 2007 and 2008 was seven days or less. Larry was active in advertising his boats to generate bareboat or skippered charters and specifically targeted his marketing efforts towards pilots at Southwest and other airlines. His efforts paid off because each of the times that he chartered one of his boats during the years at issue (i.e., 2007 and 2008), it was to skipper a charter for friends and acquaintances from Southwest and other airlines (Kline charters). In addition to Larry and Christine, three couples participated in each of the 2007 Kline charters, three couples participated in one of the 2008 Kline charters, and two couples participated in the other.

Generally, the expenses for each Kline charter were divided equally among the participants, and a 10 percent fee was added as a profit margin. Following each Kline charter, Larry would send an invoice to the participants for the amount owed. Larry did not owe the customary charter fee to Horizon in connection with the Kline charters.

Larry reported the income from the Kline charters along with the income from the other term charters on the Schedules C attached to the Forms 1040 for 2007 and 2008. On Larry's single return for 2007 and Larry and Christine's joint return for 2008, losses of $105,930 and $98,371, respectively, were reported on Schedule C from the boat charter business.

During an audit, the IRS asked Larry to provide the number of hours spent in connection with the charter activity. While Larry and Christine did not maintain a contemporaneous log of the time spent, Larry did maintain copies of email communications with Horizon. Using this correspondence and records of the length and destination of the Kline charters, Larry and Christine were able to develop a log of the time they spent. The log reflected totals of 470 hours for 2007 and 732.5 hours for 2008. The hours reflected in these totals were based on the following three categories: (1) the boat business, which involved running the charter business, including communication with Horizon, working on administrative aspects, and related matters; (2) advertising, which included promoting the charter business to the public; and (3) the Kline charters, including the preliminary planning and determination of the participants' needs for each trip.

Of the 470 hours for 2007, 386.5 hours were spent by Larry in connection with the two Kline charters. Of the 732.5 hours for 2008, 365.5 hours were attributable to Larry, 271.5 of which were for time he spent in connection with the two Kline charters. The remaining 367 hours for 2008 were attributable to Christine, 254 of which were for the time she spent on the Kline charters.

IRS and Taxpayer Arguments

While the IRS conceded that Larry and Christine were engaged in a charter boat business during 2007 and 2008, it determined that the couple did not materially participate in the business. Thus, the IRS said the losses from the business were passive activity losses that could not be deducted against nonpassive income. Losses are not considered passive if the taxpayer materially participates in the activity. Under Code Sec. 469(h)(1), a taxpayer materially participates in an activity if he or she is involved in its operations on a regular, continuous, and substantial basis. A taxpayer can establish material participation by satisfying any of seven tests provided in Reg. Sec. 1.469-5T(a).

Larry and Christine argued that they satisfied the material participation test in Reg. Sec. 1.469-5T(a)(3). That regulation provides that for purposes of Code Sec. 469, an individual is treated as materially participating in an activity for the tax year if and only if the individual participates in the activity for more than 100 hours during the tax year, and such individual's participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year. For purposes of this test, if a taxpayer's spouse participates in the activity, it is treated as participation by the taxpayer.

The IRS's principal contention was that the Kline charters were personal and that time spent with respect to them did not count towards meeting the material participation test.


The Tax Court held that Larry and Christine materially participated in the charter boat business and thus could deduct the losses from the business against nonpassive income. The court looked at whether the Kline charters were personal, noting that this was a critical distinction for 2007 because Larry spent less than 100 hours on the charter business if the time he spent on the Kline charters was not counted.

The court also noted that some of the activities other than those connected with the Kline charters could be considered investor activity and thus not count towards material participation. Accordingly, the primary issue before the Tax Court hinged on whether the time Larry and Christine spent before and during the Kline charters could be counted towards the hours needed to qualify under the material participation test in Reg. Sec. 1.469-5T(a)(3).

Larry, the court observed, continued to work as an airline pilot during the years at issue, and he focused his marketing efforts on other pilots. The court said that the fact that Larry's friends and acquaintances were the Kline charter participants did not, per se, make those charters personal vacations or preclude them from being counted for purposes of the material participation test. According to the court, while Larry and Christine may not have owed the customary charter fee to Horizon in connection with the Kline charters, they engaged in these charters for a profit because they divided the expenses for the Kline charters among the participants and added a 10 percent profit margin, and the income from these charters was included on their Schedules C. The court found that the time Larry and Christine spent preparing for and sailing on the Kline charters could be considered for purposes of determining whether Larry materially participated in the charter business. The purpose of the material participation test, the court observed, is to distinguish actively participating in the operation of a business from investor type activity.

Though Larry and Christine did not contemporaneously record their time, the court found the time entries they provided to be reasonable reconstructions of the hours that they spent in the charter business and consistent with the requirements of Reg. Sec. 1.469-5T(f)(4). In addition, the court concluded that, on the basis of the invoices Horizon sent to Larry and Christine regarding work done on the boats and the testimony of Horizon's operations manager during the years at issue, Larry and Christine spent more time in connection with the boats than any individual employed by Horizon.

For a discussion of the seven material participation tests under the passive activity loss rules, see Parker Tax ¶247,115. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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