If the expenses of your activity exceed its revenues, you probably think you can deduct the net losses as business losses. However, the IRS may claim that purported business is a hobby that never had a chance of being profitable. The IRS likes to make that argument because the tax rules for hobby losses are not in your favor. Here's what you need to know about the business-versus-hobby issue along with summaries of some recent Tax Court decisions on the issue. As you will see, there are reasons for hope.
Why It Matters
When an individual unincorporated for-profit business venture generates a net loss for the year (deductible expenses in excess of taxable revenue), you can usually deduct the full loss currently on Form 1040 (assuming no problems with tax law limitations such as the passive loss and at-risk rules).
Schedule C is used to report a loss from a sole proprietorship business; Schedule E is used for a rental activity; and Schedule F is used for a farm or ranch or other agricultural business. The loss is then carried from the applicable Schedule to page 1 of your Form 1040 where it offsets income from all other sources and reduces your tax bill. Great!
What happens if the activity is deemed to be a not-for-profit hobby? Not great. You must report all the revenue on page 1 of Form 1040, using the "other income" line (line 21 on the current version of Form 1040. However, your allowable expenses from the hobby business are limited to the amount of that revenue and are treated as itemized deductions because they are not from a business activity. Basically, you cannot have a net tax loss from a hobby even if you lose your shirt. Worse yet, you must treat allowable hobby expenses (other than the expenses that can be deducted in any event, such as home mortgage interest and property taxes) as itemized deduction items that are subject to the dreaded 2%t-of-AGI deduction threshold . So, you get no write-off unless you itemize. Even if you do itemize, your miscellaneous itemized deductions are limited to the excess of those items over 2% of AGI. If you have a healthy AGI, your deduction for hobby expenses may be little or nothing. Finally, if you're a victim of the dreaded AMT, miscellaneous itemized deductions for hobby expenses and property taxes allocable to hobby losses are disallowed for AMT purposes.
When all is said and done, you can easily have a money-losing hobby that actually adds to his or her taxable income because all the income must be reported and the client deductible expenses may amount to little or nothing. The client's tax bill goes up accordingly.
Now you understand why the Feds are so enthusiastic about making the hobby loss argument. But, don't give up hope! The good news is yet to come.
Determining If the Activity Is Business or Hobby
Safe-harbor Rules. The tax law provides two safe-harbor rules for determining if you have a for-profit business. The first safe-harbor rule presumes that an activity is a for-profit business activity if it produces positive taxable income (revenues in excess of deductions) for at least three out of every five years . Losses from the other years can be deducted because they are considered to be business losses as opposed to hobby losses. The second safe-harbor rule is for horse racing, breeding, training, or showing activities. Under that rule, you are presumed to have a for-profit business activity if you can generate positive taxable income in two out of every seven years . You can plan ahead to qualify for these safe-harbors earn the right to deduct their losses from unprofitable years.
Intent to Make Profit. Even if you cannot qualify for one of these safe-harbor rules, you may still be able to treat the activity as a for-profit business and rightfully deduct the losses. Basically, you must demonstrate an honest intent to make a profit. According to these factors they can prove or disprove this intent include:
- Conducting the activity in a businesslike manner by keeping good records and searching for profit-making strategies.
- Having expertise in the activity or utilizing the advice of hired experts.
- Spending enough time to justify the notion that the activity is a business and not just a hobby.
- Expectation of asset appreciation (this is why the IRS will almost never claim that owning rental real estate is a hobby even when tax losses are incurred for many years).
- Success in other ventures, which indicates business acumen.
- The history and magnitude of income and losses from the activity: occasional large profits hold more weight than more frequent small profits, and losses caused by unusual events or bad luck are more justifiable than ongoing losses that only a hobbyist would be willing to accept.
- Financial status—rich folks can afford to absorb ongoing losses (which may indicate a hobby) while ordinary folks are usually trying to make a buck (which indicates a business).
- Elements of personal pleasure—racing horses is more fun than cleaning out septic tanks, so the IRS is far more likely to claim the former is a hobby if losses start showing up on your returns.
Little-used Election to Postpone Safe-harbor Presumption. You can elect to delay a determination as to whether one of the previously discussed safe-harbor rules is available until the close of the fourth tax year after the tax year in which the client first engaged in the activity; or the sixth year for horse racing, breeding, training, or showing activities. To make the election, your CPA files Form 5213 (Election to Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit). The election automatically extends the statute of limitations for all years in the five-year or seven-year determination period until two years after the due date (without considering extensions) of the return for the last tax year in the determination period. However, the statute of limitations is extended only for items related to the activity and other items on the return that would be directly affected by deductions from the activity. The big downside of filing Form 5213 is that it alerts the IRS to a possible hobby loss issue. Therefore, Form 5213 is rarely used until after a taxpayer has been notified that the IRS proposes to disallow deductions related to an alleged hobby activity.
Recent Tax Court Decisions Have Gone Both Ways
As the following summary of selected Tax Court decisions from the 2011-2014 time frame illustrates, the court has sometimes found in favor of taxpayers, and sometimes it has not. The key point is that taxpayers have won in a number of cases where you might have thought optimism was unwarranted.
Breeding, Training, and Racing Horses (Partial Win). In Roberts , TC Memo 2014-74, the Tax Court concluded that a former restaurant and nightclub owner who bred, trained, and raced horses was operating what was intended to be a for-profit business for two out of the four tax years in question. Therefore, the taxpayer's net losses from 2007 and 2008 could be deducted, even though the race horse activity never generated a profit. The allowable losses were $98,251 for 2007 and $291,888 for 2008. The following factors indicated a profit motive for those two years.
- The taxpayer sold his old unsuitable race horse training facility and moved his operation to a new property on which he built a premier training facility.
- He hired an assistant trainer and consulted with bloodstock agents and respected trainers on various horse racing issues. So, he relied on the advice of experts.
- His accounting methods allowed him to make informed business decisions. Thus, he conducted his race horse activity in a businesslike manner.
- For the two years, the taxpayer's reasonable expectation that the land value of his horse training facility would appreciate was an element of his overall for-profit objective for those years.
- He spent substantial time in the activity.
- He had been successful in previous business ventures.
Selling Sports Memorabilia (Loss). In Akey , TC Memo 2014-211 , the Tax Court concluded that the taxpayer, who had a full-time job as a software engineer, did not engage in his side business of selling sports memorabilia with a profit motive, based on an analysis of the factors found in Reg. 1.183-2(b) . The taxpayer did not keep accurate books and records, was not an expert (nor did he consult with experts), did not devote much of his personal time to the activity, did not insure his collection, had a history of substantial losses, and had substantial income from other sources. Consequently, the hobby loss deduction rules applied.
Producing and Selling Artwork (Win). In Crile , TC Memo 2014-202 , a longtime artist and tenured art professor claimed losses from selling her artwork in most of the years of her artistic career. The Tax Court concluded that she was not subject to the hobby loss deduction limitation because she met several of the factors outlined in Reg. 1.183-2(b) and, therefore, demonstrated a profit motive for her business of being an artist. Specifically, she conducted the activity in a businesslike manner, had expertise and understanding of the economics of the business, devoted substantial time and effort to the business, and had a reasonable expectation that her artwork would appreciate significantly over the course of her career.
Sprint Car Racing (Loss). In Sernett , TC Memo 2012-334 , the taxpayer was a salesman who raced sprint cars in his spare time under the name Sernett Motorsports. He owned several cars, a semitrailer to transport them, and he leased or owned a shop where the cars were taken care of. From 2000–2010, the taxpayer deducted losses from the sprint car racing activity totaling $629,470. Of the factors listed in Reg. 1.183-2(b) , the Tax Court opined that four indicated hobby status, two indicated business status, and three were neutral. In addition, because the taxpayer's racing activity was a mature venture, the Tax Court placed heavy emphasis on the history of significant and sustained losses and the taxpayer's apparent inability to reduce expenses or increase income. All things considered, the Tax Court concluded that the taxpayer did not have an honest profit objective in conducting the racing activity. Therefore, the losses claimed for the tax years in question were disallowed as nondeductible hobby losses.
Drag Racing (Loss). In Johnson , TC Memo 2012-231 , the taxpayer worked for companies that developed automotive performance products and also conducted a part-time drag racing venture in which he invested 20 to 50 hours per week. The racing activity never earned a profit, and the Tax Court opined that it was a nondeductible hobby rather than a legitimate business. In reaching this conclusion, the Tax Court applied the factors listed in Reg. 1.183-2(b) .
Private Track and Field Coaching (Win). In Parks III , TC Summary Opinion 2012-105, the taxpayer was employed as a track and field coach and had coached for many years at the college and high school levels. The taxpayer began a private coaching venture on the side and over a nine-year period deducted losses totaling $153,488. The Tax Court concluded the losses were allowed because the private coaching activity qualified as a legitimate business. Factors in the taxpayer's favor included the following: he had unquestioned expertise as a track and field coach, he used a business-like approach by seeking ways to improve his financial results and abandoning things that did not work, he devoted lots of time to the private coaching activity that negatively affected his marriage and personal life, and his salary from his regular coaching job was modest, which indicated that he would be motivated to make the private coaching activity profitable.
Glider Flying (Win). In Weller , TC Memo 2011-224 , the Tax Court ruled that the taxpayer's unprofitable glider flying business was a business rather than a hobby. The taxpayer provided glider flying lessons and rides and incurred relatively modest tax losses due to depreciation deductions for the plane. Even though the taxpayer enjoyed flying, had a regular full-time job, and failed to keep great records, the evidence showed he intended to make a profit. He maintained a website, actively promoted the business, devoted his weekends to it, and tried to keep his expenses low.
Conclusions
Business status is good for deducting losses. Hobby status is bad. As you can see from the Tax Court decisions summarized above, a number of pleasurable activities have recently been found to be for-profit businesses rather than mere hobbies, based on evaluating the relevant factors listed in. There is hope in appropriate situations (which may not include drag racing). In any case, the hobby loss issue is still a hot button item for the IRS. Therefore, it is important for you to be on the right side of as many of the relevant factors as possible. We can help with that.
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