Sullivan v. Commissioner

Executive Writes Off Porn App & Tent Living Costs

A high-income tech executive, earning approximately $350,000 annually, successfully challenged the IRS, managing to deduct losses from a pornography addiction app and 75% of his costs associated with developing off-grid homes while living in a tent. The Tax Court rejected the IRS's assertion that these ventures were mere hobbies under Section 183, which limits deductions for activities "not engaged in for profit." However, the court did carve out the taxpayer's personal campsite expenses from the deductible amounts.

From High Tech to the Maine Woods

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From High Tech to the Maine Woods

The Sullivans' journey to the Tax Court began far from the rustic Maine landscape that would become central to their dispute. Neither Mr. nor Ms. Sullivan attended college, but the court record makes clear they are intellectually curious and have amassed significant self-taught expertise across various fields. Mr. Sullivan started his career in telecommunications hardware installation. After the couple married in 1980 and moved to Minnesota in 1981, he transitioned to the cable television industry, gaining experience with cable-based advertising as a staff engineer and director of engineering for two companies.

Around 1985, the Sullivans embarked on their first home construction project, intending it as their primary residence. Mr. Sullivan oversaw subcontractors, while Ms. Sullivan handled landscaping, design, and site maintenance. They both operated heavy equipment. Upon moving to Montana, they sold the Minnesota residence for a profit.

In 1987, Mr. Sullivan planned to launch North Broadcasting, a television station business. The Sullivans purchased 20 acres of land in Montana to build another primary residence. Again, they managed subcontractors, performed architectural and design work, operated heavy equipment, and completed construction tasks. This Montana residence was ultimately sold at a loss when the Sullivans relocated to the East Coast.

Mr. Sullivan accepted a job with Channelmatic in Connecticut in 1989 as a traveling salesman of computer equipment for television advertising. A year later, he became general manager for Media Partners, a cable company in Boston, Massachusetts. In 1993 or 1994, he joined Continental Cable as director of engineering and operations, facilitating the installation of infrastructure for early cable modem internet access in Boston. Mr. Sullivan left Continental Cable in 2003.

After nearly a decade of renting, the Sullivans purchased a historic home in Hingham, Massachusetts, in 1999. The property was in disrepair, and the Sullivans undertook extensive renovations and additions. Mr. Sullivan managed subcontractors, operated heavy machinery, and performed architectural design. Ms. Sullivan assisted, and together they completed tasks like painting, installing windows, and building stairs. They sold the Hingham residence in 2018 for a $350,000 profit.

In 2005, Mr. Sullivan took a break from employment to work on Traders Abacus's initial project. He then became senior director of product marketing for Open TV, a company developing television advertising software. He later became a senior director of sales in 2009. Imagine Communications acquired Open TV in 2014 and employed Mr. Sullivan throughout the years in question. His compensation at Imagine was partially commission-based, and he sometimes earned more than the CEO. In 2014, Mr. Sullivan and Imagine agreed to protect his intellectual property rights related to his software ventures. He served as Imagine's vice president of sales in 2017, 2018, and the latter half of 2019, earning taxable wages of $355,734, $178,332, and $226,857, respectively. Ms. Sullivan did not work outside the home during these years.

The Ventures: SelfChanger and The Lincolnville Lot

Following his role at Imagine, Mr. Sullivan channeled his energies into two primary ventures through Traders Abacus: the development of the "SelfChanger" application and the acquisition and development of the Lincolnville lot in Maine.

The Software Analysis: Businesslike Failure

Mr. Sullivan initially conceived SelfChanger in 2013 or 2014 while at Imagine, driven by his observation that a significant portion of internet bandwidth was consumed by pornography. He envisioned an internet-based application to address pornography addiction. Over 2015 and 2016, he devoted substantial resources to the project, researching therapeutic methods and hiring individuals with expertise in TensorFlow (a machine learning program) to automate therapeutic script generation. Development stalled in 2016 due to technological limitations. Mr. Sullivan revived SelfChanger in 2018, funding the effort with proceeds from the sale of his residence, his Imagine wages, and retirement savings. This time, he shifted to a manual content creation approach. In March 2019, he hired Emily Sirianni to assist with content development and customer surveys, paying her $10,354 in wages. He also created a business plan, purchased advertising on pornography websites, and generated financial projections. Despite these efforts, SelfChanger generated no income from 2013 to 2019. Early prototypes were functional in 2020, leading to a subscription-based model charging $9.99 per month, projecting $5.95 in profit. Development ceased again in early 2022 due to customer retention issues. As of the trial, Mr. Sullivan maintained the application at a cost of $35 per month, hoping to revive it with a new monetization strategy.

The Construction Analysis: A Tale of Two Parcels

Around 2017, the Sullivans sought property along the eastern seaboard to develop "passive homes"—energy-efficient homes requiring minimal energy. They were attracted to a 51.6-acre lot in Lincolnville, Maine, due to its size, price, accessibility, and frontage on Route 1. The Lincolnville lot consisted of two parcels: a 47.71-acre parcel and a 3.89-acre parcel. On October 13, 2017, the Sullivans, personally and through Traders Abacus, agreed to purchase the lot for $300,000. The sale closed on February 8, 2018, with the Sullivans and Traders Abacus each paying $150,000 for their respective parcels and taking out a mortgage using the lot as collateral.

In December 2017, the Sullivans acquired a Bobcat excavator and a track loader, receiving safety and maintenance training. They also purchased shipping containers for storage. Before closing, they conducted due diligence, engaging an engineering firm to assess wetlands and septic tank locations and obtaining a highway entrance permit waiver from the State of Maine Department of Transportation. They devoted most of Mr. Sullivan’s salary to the Lincolnville lot's development, drawing upon retirement savings and forgoing recreational spending. Weekends were spent working on the lot before moving there full-time in August 2018. The Sullivans lived a spartan existence, sleeping in a tent with an electric blanket and using YMCA facilities. In spring 2019, they upgraded to a more robust tent, living there year-round until January 2025. They also hired laborers for home construction, including Wyatt Porter, Vincent Kwialkowski, and Randall Rowling, using Gusto payroll processing software.

On April 9, 2018, Mr. Sullivan submitted a land use application for the 3.89-acre parcel owned by Traders Abacus, proposing a residence, barn, and storage units. A wastewater disposal application indicated plans for a four-bedroom, single-family dwelling. The project was intended as a temporary improvement to their living conditions, but rising material costs made it financially infeasible. The Sullivans continued residing on the parcel until January 2025.

From 2017 to 2019, Ms. Sullivan led development efforts on the 47.71-acre parcel. She operated the Bobcat equipment to clear land, mulch trees, build roads, install a septic system, and clear debris, working long hours, including holidays. She joined the Maine Forestry Owners’ Association for relevant information. In spring 2018, a location for Traders Abacus’s office was identified, with construction beginning in 2019 using modified shipping containers. The office was occupied in early 2020. The passive homes never materialized, and the Sullivans' efforts culminated in constructing access roads. In January 2025, the 47.71-acre parcel was sold for $565,000.

The 'Solomonic' 75/25 Split

Starting around 2019, Ms. Sullivan operated a landscaping and mulching business under the name "Leaf-Cutter," using the Bobcat excavator purchased for the Lincolnville lot. Leaf-Cutter was not a separate entity and used Traders Abacus’s tax identification number and bank accounts. Mr. Sullivan managed Leaf-Cutter’s finances. After safety incidents, the mulching business was abandoned.

The Software Analysis: Businesslike Failure

Following the abandonment of the mulching business, the court turned to the software development activities centered on the "SelfChanger" application. At issue was whether Mr. Sullivan engaged in these activities with a genuine profit motive, a crucial determination under Section 183. Section 183(a) generally disallows deductions for activities "not engaged in for profit," essentially treating them as hobbies where deductions cannot exceed income.

The IRS argued that the sustained losses from 2005 to 2022 indicated a lack of profit motive, pointing to the absence of profits and the long development period. The Sullivans countered, arguing that the losses were incurred during the startup phase of a high-risk, high-reward venture.

The Tax Court, in its analysis, applied the nine factors outlined in Treasury Regulation § 1.183-2(b) to assess Mr. Sullivan's intent. These factors consider the manner of operation, expertise, time and effort, expectation of asset appreciation, past success, history of income/loss, occasional profits, financial status, and personal pleasure derived from the activity. The court emphasized that no single factor is dispositive, and greater weight is given to objective facts over subjective statements.

Crucially, the court found that Mr. Sullivan did operate the software development activity in a businesslike manner. The court noted that Mr. Sullivan created a business plan, conducted surveys to identify a consumer base, hired employees with relevant expertise (including a sociologist and software engineers), and ran advertisements. While the Sullivans did commingle some funds, they maintained separate bank accounts and ledgers for Traders Abacus. The court also gave weight to Mr. Sullivan's decision to simplify the application at times and even shelve it entirely when he deemed it unprofitable, showcasing an effort to control losses, as highlighted in Carmody v. Commissioner, T.C. Memo. 2016-225.

Regarding expertise, the court acknowledged Mr. Sullivan's background in sales, digital advertising, and communications, along with his self-study of human psychology and addiction. The hiring of skilled employees like Ms. Sirianni (with a sociology degree) further bolstered the argument that he sought expert advice.

The court also credited the significant time Mr. Sullivan dedicated to the venture, even while holding a full-time job. He spent 20 to 30 hours per week on SelfChanger, which indicated his serious intent to profit.

Even though Mr. Sullivan never obtained a formal appraisal for the app, the court concluded that he had a "reasonable expectation" that it could appreciate in value based on his market research and digital marketing experience. His efforts to protect the intellectual property further suggested this expectation. The court also found that the losses were within a reasonable startup period, and that Mr. Sullivan was willing to sustain continued operating losses because of his expectation that the assets used in the activity would increase in value.

Despite the absence of profits, the court concluded that Mr. Sullivan engaged in the software development activities with a profit motive. This determination hinged on the businesslike manner in which he operated, his acquisition of expertise, his dedication of time and effort, and his reasonable expectation of asset appreciation. This case highlights the importance of demonstrating a credible business plan, seeking expert advice, and adapting strategies in response to market conditions, even in the face of sustained losses.

The Construction Analysis: A Tale of Two Parcels

Having concluded that Mr. Sullivan engaged in software development with a profit motive due to his businesslike approach, expertise, dedication, and expectation of asset appreciation, the court then turned to the real estate activities. The central issue was whether the Sullivans' construction activities on the Lincolnville lot constituted a business engaged in for profit under Section 183. Section 183, often called the "hobby loss rule," limits deductions for activities not engaged in for profit, restricting deductions to the extent of income generated by the activity.

The Sullivans funded their construction with Mr. Sullivan’s wages and retirement savings, mirroring their approach to the software venture. They hired laborers and used software to manage payroll, but lacked a formal written business plan. Mr. Sullivan testified that the Lincolnville lot aligned with their plan to develop a minor subdivision of passive homes. While the absence of a formal plan isn't determinative, according to Annuzzi v. Commissioner, T.C. Memo. 2014-233, the Sullivans treated the 3.89-acre parcel as their primary residence, which complicated matters. Mr. Sullivan expressed a desire for the entire lot to be their long-term home, promising Ms. Sullivan a house within five years.

The Sullivans presented a driveway permit waiver, a land use application, and a wastewater disposal system application to demonstrate their profit motive. However, the court noted that these documents pertained specifically to the 3.89-acre parcel and described a single-family dwelling, not the planned passive homes.

The court drew a distinction between the two parcels: the 47.71-acre parcel and the 3.89-acre parcel. The court found that the evidence suggested a businesslike approach to the larger parcel, but a personal residential approach to the smaller one.

Regarding expertise, the Sullivans had no formal training in home construction but possessed extensive experience, having remodeled or constructed a new home each time they moved. Two of their previous homes sold for a profit. Ms. Sullivan testified about relying on advice from members of the Maine Forestry Owners’ Association, though she did not specify whom she spoke to or what advice she received, similar to Mr. Sullivan's vague references to experts in the software context, as seen in Stettner, T.C. Memo. 2017-113. Despite the IRS's argument that the scale of the passive home plan was inconsistent with prior projects, the court found that the Sullivans' experience indicated a sufficient profit motive for the Lincolnville lot project, particularly the 47.71-acre parcel. Their history of flipping homes helped them establish a profit motive. However, the court clearly stated that these factors favored the Sullivans with respect to their home construction activities on the 47.71-acre parcel, but not the 3.89-acre parcel.

The 'Solomonic' 75/25 Split

Having established that the Sullivans held a profit motive with respect to the 47.71-acre property, but not the 3.89-acre parcel, the court then turned to the matter of allocating expenses. The court readily dismissed Ms. Sullivan’s mulching business, "Leaf-Cutter," finding the Sullivans failed to prove it was engaged in for profit. The court noted the lack of income reported, the significant expenses claimed, and the absence of credible time records.

The central challenge, however, lay in the commingling of expenses related to the two parcels of the Lincolnville lot. Because the Sullivans used the same equipment and labor for both the 47.71-acre (business) and 3.89-acre (personal) parcels and failed to keep separate books, the Tax Court found it inappropriate to simply allocate expenses based on the relative land area. The court stated that it did not believe the expenses were incurred in proportion to the total land area of each parcel.

Instead, the court invoked a "special allocation," implicitly drawing upon the principles of Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930). While Cohan isn't explicitly mentioned, the Tax Court's reference to the "Sullivans' lack of recordkeeping and any resulting inexactitude weigh[ing] heavily against them" echoes the Cohan rule, which allows a court to estimate expenses when a taxpayer demonstrates they incurred deductible expenses but lacks precise records. The court weighed the fact that the majority of the Sullivans’ efforts appeared to benefit the 3.89-acre parcel, intended for personal use, against the fact that the 47.71-acre parcel ultimately housed the business office and was sold for a profit.

Ultimately, the court allocated 75% of the Lincolnville lot development expenses to the 47.71-acre parcel (the business endeavor) and 25% to the 3.89-acre parcel (the personal residence). The court held that the Sullivans were entitled to deductions for all expenses incurred to develop SelfChanger, and 75% of all expenses incurred to develop the Lincolnville lot, to the extent they are substantiated in further proceedings.

The takeaway for practitioners is clear: meticulously separate business and personal expenses. The difference in the acreage (3.89 acres versus 47.71 acres) was not enough to overcome the commingling of resources and lack of detailed records. Taxpayers must maintain clear documentation to support expense allocations, or risk a court-imposed allocation that may not fully reflect their business activities. As a final point, the court rejected any notion that Ms. Sullivan was running a legitimate "Leaf-Cutter" mulching business, effectively deeming it a hobby with no profit motive.