Don’t Step in the Hobby Loss Tax Trap
Stan Rose, Director, Tax Practice
We often field questions regarding whether a person’s business expenses are deductible. The answer often is not straightforward when the “business endeavor” combines elements of both work and play. Generally, a person who engages in an activity to make money can deduct his or her expenses (cost of supplies for an architect, for instance). A person who engages in an activity just for fun generally cannot deduct those costs (no need to keep those jet-ski rental receipts!). However, in the middle are a number of things that resemble both business and personal activities. Are you moonlighting as a photographer? Do you make and occasionally sell your own art or crafts? This “middle” category has its own set of rules, known as hobby loss rules, that cause otherwise deductible expenses to be greatly limited, even for participants who claim to be (and believe they are) running a business. The purpose of the rules is to prevent people from lowering their taxes by deducting costs of recreation, and the IRS has been quite successful in making assessments against taxpayers in this area. However, some of these taxpayers likely could have improved their chances of persuading the IRS if they made just a few changes in the way they conducted their activities. The purpose of this article is to help the reader understand the differences between these types of expenses.
Not all categories of expenses are alike
An individual’s expenses generally fall into one of four tax categories:
- Business expenses (governed by IRC Section 162), which include “ordinary and necessary” costs of running a trade or business;
- Rental and investment expenses (Section 212), which include costs incurred to produce non-business income;
- Personal expenses (addressed in a number of IRC Sections), which can include a number of expenses, such as alimony or mortgage interest; and
- Hobby expenses (Section 183).
Hobby expenses are very much like business or investment expenses in that the same outlay may represent a Section 162 or 212 cost for one taxpayer, but a Section 183 cost for another taxpayer. Oversimplifying, the costs are governed by Section 162 or 212 if the taxpayer has a profit motive, and governed by Section 183 if not.
Tax treatment of various costs
The distinction matters because some categories of deductions are more potent than others. Generally, Sections 162 and 212 business and investment expenses can not only offset revenues from those endeavors, but net losses from them (expenses that exceed revenues) often can offset completely unrelated income, such as wages. Also, if not fully deductible in the year incurred, they often can be carried forward (and sometimes backward) to offset income in other years. A taxpayer is given multiple opportunities to utilize a Section 162 or 212 deduction. In contrast, generally Section 183 hobby expenses are limited to the amount of revenue earned from the same activity, and any excess generally is completely lost. In other words, you can deduct sufficient hobby losses to break even, but you cannot report a loss.
Hobby vs. business: How to tell the difference
As mentioned earlier, what distinguishes Sec. 183 “hobby” costs from Sec. 162 business and Sec. 212 investment costs is the existence of a profit motive. Although this sounds simple, the determination of whether profit motive exists can be subjective and tricky. How can anyone measure it? Wouldn’t we all prefer profit over loss? Well, preference does not equal motive, and the U.S. Supreme Court, in Commissioner v. Groetzinger, said that “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. . . . A sporadic activity, a hobby, or an amusement does not qualify” [emphasis added].
These criteria are subjective. Unfortunately, we are left with a “facts and circumstances” analysis in most cases. Worse, the taxpayer bears the burden of proof. This means that if the IRS asserts you are involved in a hobby rather than a business, and you assert to the contrary but neither side can prove its subjective assertion, the IRS wins by default. Let’s examine some of the ways a taxpayer may be confident that outlays represent business or investment costs rather than hobby costs.
Treasury Regulations are written by the IRS to supplement the Internal Revenue Code and carry the force of law.
Regulation §1.183-2 provides a list of nine factors to help determine whether an activity is engaged in for profit. The IRS stresses that no one factor is determinative and the list is not exhaustive (other factors may be considered). Also, a determination is not necessarily reached once a majority of the factors are designated in the “yea” or “nay” column. Instead, these simply number among the things to be considered. Those factors are:
- Manner in which the taxpayer carries on the activity.
- The expertise of the taxpayer or his advisors.
- The time and effort expended by the taxpayer in carrying on the activity
- Expectation that assets used in activity may appreciate in value
- The success of the taxpayer in carrying on other similar or dissimilar activities
- The taxpayer’s history of income or losses with respect to the activity
- The amount of occasional profits, if any, which are earned
- The financial status of the taxpayer
- Elements of personal pleasure or recreation
That Regulation, which contains detailed descriptions of these factors and related examples, can be found here.
Presumption of profit motive
I mentioned above that the burden of proof is on the taxpayer to show profit motive, and if neither side can prove its case, the IRS wins. That burden can be shifted by using a provision in IRC Section 183(d). If an activity turns a profit in 3 out of 5 years, the intent of profit is presumed to exist for the first year of profit in that group, and the 4 years that follow. In other words, if you “win” 3 out of 5, you are “given” the other 2. (Apparently, the more the government coffers are filled, the more inclined it is to see your way of thinking!) The IRS can still question profit motive, but it is less likely they will do so, and now the burden of proof will be on them rather than you.
Because of the subjective nature of the rules, many quibbles with the IRS over profit motive end up in court. Here are a few random examples of such cases and their outcomes:
- A taxpayer’s horse-riding and cattle-rearing operations were considered a hobby. The taxpayer had no formal training, did not conduct the operations in a businesslike manner, and supported repeated losses with income from other means (98-2 USTC ¶50,562).
- A taxpayer’s dairy farm was considered a business in spite of repeated losses. The taxpayer’s efforts to learn more about farming were evidenced by reading of trade journals and solicitation of advice from experts, and his hard work overcame any element of enjoyment derived from the activity (83-1, USTC ¶9217).
- A taxpayer’s yacht rental activity was not engaged in primarily for profit. In this case, the Tax Court systematically addressed each of the nine factors listed in Regulation §1.183-2, concluding each one pointed toward this activity serving as a hobby rather than a business (T.C. Memo 2012-96).
- Richard Miller’s horse-breeding activity was a trade or business. Even though Mr. Miller owned a horse that he rode for pleasure, he kept that activity separate from his business activity, which he conducted in a professional, businesslike manner (T.C. Memo 2008-224).
- Peter Morton (founder of Hard Rock Café) could deduct losses from operating an aircraft because the plane was deemed to support his overall “unified business enterprise,” which consisted of numerous endeavors.
Applying what we have learned
With the background provided above, how can you increase the odds your endeavor will legitimately be viewed as a trade or business as opposed to a hobby? Each fact pattern is different, and there is no one piece of advice that will put every taxpayer over the top. However, there are some easy-to-implement changes that may help you make your case. Here are some observations:
- First, you can nearly guarantee that the nine factors of Regulation §1.183-2 will enter the picture when the IRS questions a taxpayer’s profit motive.
- Second, some of the nine factors are more controllable than others, and although the IRS notes in Regulation §1.183-2 that no one factor is determinative, it appears that some are routinely given more weight than others. Impact the ones you can control. Factors five through nine are more or less out of the taxpayer’s control. However, the taxpayer can make adjustments for factors one through four to improve his or her argument of a primary profit motive.
- Factor one: This factor appears to be the most important the most often. It is critical to keep good records. Losing taxpayers sometimes retained little more than a boxful of records or a commingled checking account. By contrast, winning taxpayers maintained separate, accurate financial statements. They routinely reviewed the financial records, and made changes in the way they ran the business if analysis suggested they should. Often, they had a written business plan and a budget.
- Factor two: Most people running a business have had some training in that area or have some level of expertise. The ones who lack those skills gain them or hire those who have them. The more formal, the better. In one case, a losing taxpayer argued that he engaged experts, but the court concluded he really was nothing more than a retail customer who may have solicited occasional advice. In contrast, winning taxpayers found, and often paid for, expertise they did not directly possess, and they implemented the advice they received.
- Factor three: This factor (time and effort) appears to be important, but much less so than Factor 1, as people often devote significant effort and time to endeavors undertaken solely for pleasure.
- Factor four (expectation of profit) appears to be given great weight by the IRS. The taxpayer’s beliefs do not have to come to fruition, and do not necessarily have to be reasonable, as long as the taxpayer can show he or she believed it and that it had a bearing on the taxpayer’s involvement in the activity. You must, however, be prepared to show why you believed profit would exist.
- The IRS follows specific steps once it identifies a trade or business deduction that they believe should be re-categorized as a hobby expense. Those steps are listed in one of many guides the IRS produces for its agents to use while conducting exams. It shows the types of questions a taxpayer should be prepared to answer if hobby expenses are raised as part of an audit, and familiarity with it may be helpful in making your case (or making changes). That guide can be found here.
Trade or business and investment expenses are much more beneficial to many taxpayers than hobby expenses. However, to avoid the limitations of the hobby loss rules, a taxpayer must be able to prove that profit was the primary purpose of the undertaking. Hopefully by reading this article you have gained a little insight into the characteristics of a profit-motivated activity, and you can use that knowledge to avoid the IRS trap.
If you would like to discuss further, please call your BNN advisor or Stan Rose at 1-800-244-7444.
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