Hobby Losses

 

 

The Internal Revenue Code restricts taxpayers from deducting expenses for activities that are not engaged in for profit.  These are commonly referred to as "hobby losses." 

The IRS in 2007 posted on the IRS.GOV website a fact sheet that discusses the classification of an activity as one having a profit motive, or one that is an activity not engaged in for profit.  They also address the deduction of expenses related to the hobby.  This fact sheet is reprinted below:

Business or Hobby? Answer Has Implications for Deductions
 

FS-2007-18, April 2007 

The Internal Revenue Service reminds taxpayers to follow appropriate guidelines when determining whether an activity is a business or a hobby, an activity not engaged in for profit.

In order to educate taxpayers regarding their filing obligations, this fact sheet, the eleventh in a series, explains the rules for determining if an activity qualifies as a business and what limitations apply if the activity is not a business. Incorrect deduction of hobby expenses account for a portion of the overstated adjustments, deductions, exemptions and credits that add up to $30 billion per year in unpaid taxes, according to IRS estimates.

In general, taxpayers may deduct ordinary and necessary expenses for conducting a trade or business. An ordinary expense is an expense that is common and accepted in the taxpayer’s trade or business. A necessary expense is one that is appropriate for the business. Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit.

In order to make this determination, taxpayers should consider the following factors:

  • Does the time and effort put into the activity indicate an intention to make a profit?

  • Does the taxpayer depend on income from the activity?

  • If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?

  • Has the taxpayer changed methods of operation to improve profitability?

  • Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?

  • Has the taxpayer made a profit in similar activities in the past?

  • Does the activity make a profit in some years?

  • Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?

The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year — at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses.

If an activity is not for profit, losses from that activity may not be used to offset other income. An activity produces a loss when related expenses exceed income. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.

Deductions for hobby activities are claimed as itemized deductions on Schedule A (Form 1040). These deductions must be taken in the following order and only to the extent stated in each of three categories:

  • Deductions that a taxpayer may take for personal as well as business activities, such as home mortgage interest and taxes, may be taken in full.

  • Deductions that don’t result in an adjustment to basis, such as advertising, insurance premiums and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.

  • Business deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.

Link:

The Internal Revenue Code Section 183 provides a presumption of profit for activities as follows:

(d) Presumption

If the gross income derived from an activity for 3 or more of the taxable years in the period of 5 consecutive taxable years which ends with the taxable year exceeds the deductions attributable to such activity (determined without regard to whether or not such activity is engaged in for profit), then, unless the Secretary establishes to the contrary, such activity shall be presumed for purposes of this chapter for such taxable year to be an activity engaged in for profit. 

In the case of an activity which consists in major part of the breeding, training, showing, or racing of horses, the preceding sentence shall be applied by substituting ''2'' for ''3'' and ''7'' for ''5''.
 

The rule is clear - show a profit in 3 out of 5 consecutive years (2 out of 7 for breeding, etc.) and the IRS must PROVE that you are NOT in the business of making a profit.  If you do NOT meet this test, it does NOT mean you are presumed to be in the activity for other than a profit motive!   It means that you must rely on other factors (not the presumption) to persuade the IRS or a Court that you have a profit motive.  

Following is a synopsis from a 2005 Tax Court case that discusses the disallowance of a loss claimed by a dentist for his horse breeding and showing activity.  Pay particular attention to the factors that the Court considered as evidence of the taxpayer's lack of profit motive.

Code Section 183—Activities not-for-profit—horse breeding and showing—proof.

Dentist didn't engage in horse breeding and showing activities for profit: taxpayer didn't keep separate accounts or business-like records for activity, didn't operate it comparable to other profitable horse businesses, didn't try to change her operational methods to correct 14-year loss history, and didn't otherwise show that she carried on activity in valid business-like manner. Also telling were facts that taxpayer never gained expertise in horse activity and its peculiar economics, maintained fulltime dental practice while engaged in activity, didn't show any real appreciation in value of any of her horses or horse assets save one, used activity losses to offset significant income from her dental practice and investments, and drew personal pleasure from activity. (Elizabeth Giles v. Commissioner, (2005) TC Memo 2005-28)

Here is a synopsis of a 2007 Tax Court case involving the IRS's determination that an activity was not engaged in for profit.   You can see what factors the Court considered as relevant in making its determination:

Code Section 183—Activities not-for-profit—horse-boarding—profit motive—bona fide business.

Sales manager/executive's and wife's for-profit treatment of loss-generating horse-boarding activity was upheld: taxpayers conducted activity with actual profit intent as bona fide business activity within meaning of Code Sec. 183 and Code Sec. 162 . Although taxpayers admitted that, after following carefully modified business plan, they realized they would never make profit, such didn't in itself reflect lack of profit objective and was outweighed by overall evidence that they had kept meticulous records and accounts, kept operating in business-like manner until they could sell, and took steps to mitigate costs and to try and at least break even. Also, taxpayers' prior experience in owning horses well-qualified them for horse-boarding business; husband spent substantial time on such despite living hours from boarding facility; his executive management position salary wasn't so high as to easily absorb boarding losses; and taxpayers didn't derive substantial personal pleasure from boarding. (Michael J. Rozzano, Jr., et ux. v. Commissioner, (2007) TC Memo 2007-177

 

Here is a 2012 Court Case involving horse breeding:

Code Section 183—Activities not-for-profit—horse breeding, training and sales—profit motive—proof—deductions.
 

Horse breeding activity engaged in by homemaker, who held consumer finance degree and real estate license, and her attorney-husband was activity not engaged in for profit within meaning of Code Sec. 183 : overall facts and circumstances showed that instead of holding actual and honest profit objective, taxpayers engaged in activity as hobby. Factors included that despite “hemorrhaging losses” and determining that they needed to acquire their own horse facility rather than pay to board elsewhere in order to control costs and improve profitability, taxpayers waited years before even buying land on which to construct their own facility and otherwise failed to conduct activity in businesslike manner. Other factors included that activity had sustained losses which taxpayers used to offset significant income from husband's law business. Also, allegation that taxpayers' move to new area that was more hospitable to horse activity showed intent to pursue same as business was unpersuasive when considering above plus fact that new area could have been equally welcoming to horse enthusiasts as to bona fide breeders. (Peter C. Bronson, et ux. v. Commissioner, (2012) TC Memo 2012-17)

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Here is a 2019 Tax Court case in which the Court determined that the activity was not engaged in for profit.

Donoghue, TC Memo 2019-71

A married couple's losses from their horse breeding activity were disallowed. The taxpayers failed to show they had a profit motive for the activity.

Taxpayers carrying on a trade or business can deduct ordinary and necessary expenses paid or incurred while carrying on that trade or business. (Code Sec. 162) However, if the taxpayer's activity is not engaged in for profit, then the taxpayer can only deduct expenses up to the income earned from the activity. (Code Sec. 183) An activity primarily carried on for sport, as a hobby, or for recreation is not carried on for profit. (Reg §1.183-2)

The regs under Code Sec. 183 provide a nonexclusive list of nine factors to consider when evaluating a taxpayer's profit objective. (Reg §1.183-2(b)) These factors are:

  1. How the taxpayer carried on the activity;

  2. The expertise of the taxpayer and his or her advisers;

  3. The time and effort spent by the taxpayers in carrying on the activity;

  4. The expectation that assets used in the activity might appreciate;

  5. The taxpayers' success in similar or dissimilar activities;

  6. The activity's history of income or loss;

  7. The possibility of an eventual substantial profit;

  8. The financial status of the taxpayers; and

  9. The level of personal pleasure or recreation the taxpayer had in the activity. (Reg. §1.183-2(b))

In this case, the taxpayers, Mr. and Mrs. Donoghue, in 1985, started a thoroughbred horse breeding activity called Marestelle Farm, LLC (Farm). Farm was a "virtual farm". The Donoghues owned the horses but boarded them at farms and stables belonging to other people.

While the Donoghues conducted their horse breeding activity through the Farm, Mr. Donoghue was employed full time as a programmer. Mrs. Donoghue was disabled and received disability benefits.

From 1985 through 2012, the Donoghues owned six horses. However, they did not breed, race, or sell any of their horses during 2010, 2011 or 2012. The last year the Donoghues raced any of their horses was 2008. From its inception in 1985 through 2012, their horse breeding activity incurred expenses totaling $1,008,303, but realized income totaling only $33,691, resulting in accumulated losses of $974,612. From 1985 through 2012, their horse breeding activity never had a profitable year.

The IRS audited the Donoghues' returns for 2010, 2011, and 2012. In its answer to the Donoghues' Tax Court petition, the IRS disallowed the claimed losses from their horse breeding activity because the Donoghues did not engage in that activity for profit.

The Donoghues argued that they operated their horse breeding activity in a businesslike manner with the intent to make a profit. Therefore, their losses should be allowed.

Horse breeding activity not engaged in for profit

The Tax Court examined the nine factors in Reg §1.183-2(b).  The Court concluded that the Donoghues did not have an actual and honest intent to operate their horse breeding activity for profit. The eight factors weighing in the IRS's favor were:

 

  • Manner in which they conducted their horse breeding activity. During 2010, 2011 and 2012, the Donoghues did not breed, race, or sell any of their horses. The Tax Court found it was not reasonable for the Donoghues to claim that they were engaged in a thoroughbred horse breeding business when it was not engaged in breeding or racing horses.

  • Expertise of their advisors. There was no evidence in the record that the Donoghues acquired, or even sought, more expert advice about the economics of profitably running a horse breeding activity than an enthusiast would seek.

  • Time and effort devoted to the activity. The Donoghues created two spreadsheets during the audit that listed the time they spent on horse breeding activities for 2010 and 2011. However, the Tax Court found that these spreadsheets were untrustworthy because they were created from recollection and the estimated hours reflected were not associated with actual dates, but with activities performed. Moreover, there was no contemporaneous documentary evidence corroborating the hours reported by activity.

  • Expectation that assets used in the activity may appreciate. The Donoghues' only assets were their horses since they operated their horse breeding activity as a "virtual farm". However, there was no evidence in the record about the value of their horses. Therefore, the Donoghues failed to show that their horses would appreciate so much they would come close to recouping the significant losses they accumulated over the nearly 30 years of operating their horse breeding activity.

  • History of the activity's income and losses. The horse breeding activity did not earn a profit for any year since its inception in 1985. By 2010, the horse breeding activity was in its 25th year of operation and, therefore, long past the start-up phase. Moreover, while the Tax Court recognized that the horse breeding activity may have been harmed by the Great Recession, the recession could not account for the long history of losses that predated the recession.

  • Occasional profits. The horse breeding activity never had a profitable year in its nearly 30 year history, let alone a year with a substantial profit.

  • Taxpayer's financial status. The Donoghues received more than $100,000 of income for each year at issue. However, the losses generated by the horse breeding activity reduced their income tax to $538 for 2010 and zero for 2011 and 2012.

  • Personal pleasure and recreation. The possibility for profit was small compared with Mrs. Donoghue's personal gratification. The Donoghues clearly loved horses and started their horse breeding activity when Mrs. Donoghue found her dream horse, but they left the most grueling aspects of caring for the horses to paid professionals.

Updated - 2019

Taxpayers are often confused by the differences in tax treatment between businesses that are entered into for profit and those that are not, commonly referred to as hobbies. Recent tax law changes have added to the confusion. The differences are:
 

Businesses Entered Into for Profit – For businesses entered into for profit, the profits are taxable, and losses are generally deductible against other income. The income and expenses are commonly reported on a Schedule C, and the profit or loss—after subtracting expenses from the business income—is carried over to the taxpayer’s 1040 tax return. (An exception to deducting the business loss may apply if the activity is considered a “passive” activity, but most Schedule C proprietors actively participate in their business, so the details of the passive loss rules aren’t included in this article.)

Hobbies – Hobbies, on the other hand, are not entered into for profit, and the government currently does not permit a taxpayer to deduct their hobby expenses but does require the income from the activity to be declared. (Prior to the changes included in the Tax Cuts and Jobs Act of 2017, hobbyists were allowed to deduct expenses up to the amount of their hobby income as a miscellaneous itemized deduction on Schedule A. Being able to take this deduction is suspended for years 2018 through 2025.) Thus, hobby income is reported on Schedule 1 of their 1040 and no expenses are deductible.


So, what distinguishes a business from a hobby? Let's review the nine factors the IRS considers when making the decision. No single factor is decisive, but all must be considered together in determining whether an activity is for profit. The nine factors are:
 

(1) Is the activity carried out in a businesslike manner? Maintenance of complete and accurate records for the activity is a definite plus for a taxpayer, as is a business plan that formally lays out the taxpayer’s goals and describes how the taxpayer realistically expects to meet those expectations.

(2) How much time and effort does the taxpayer spend on the activity? The IRS looks favorably at substantial amounts of time spent on the activity, especially if the activity has no great recreational aspects. Full-time work in another activity is not always a detriment if a taxpayer can show that the activity is regular; time spent by a qualified person hired by the taxpayer can also count in the taxpayer’s favor.

(3) Does the taxpayer depend on the activity as a source of income? This test is easiest to meet when a taxpayer has little income or capital from other sources (i.e., the taxpayer could not afford to have this operation fail).

(4) Are losses from the activity the result of sources beyond the taxpayer’s control? Losses from unforeseen circumstances like drought, disease, and fire are legitimate reasons for not making a profit. The extent of the losses during the start-up phase of a business also needs to be looked at in the context of the kind of activity involved.

(5) Has the taxpayer changed business methods in an attempt to improve profitability? The taxpayer’s efforts to turn the activity into a profit-making venture should be documented.

(6) What is the taxpayer’s expertise in the field? Extensive study of this field’s accepted business, economic, and scientific practices by the taxpayer before entering into the activity is a good sign that profit intent exists.

(7) What success has the taxpayer had in similar operations? Documentation on how the taxpayer turned a similar operation into a profit-making venture in the past is helpful.

(8) What is the possibility of profit? Even though losses might be shown for several years, the taxpayer should try to show that there is realistic hope of a good profit.

(9) Will there be a possibility of profit from asset appreciation? Although profit may not be derived from an activity’s current operations, asset appreciation could mean that the activity will realize a large profit when the assets are disposed of in the future. However, the appreciation argument may mean nothing without the taxpayer’s positive action to make the activity profitable in the present.


There is a presumption that a taxpayer has a profit motive if an activity shows a profit for any three or more years within a period of five consecutive years. However, the period is two out of seven consecutive years if the activity involves breeding, training, showing, or racing horses.

 

Updated: 7/25/2019