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 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 alleged determination that an activity was not engaged in for profit.   You can see what factors the Court considered as relevant in making their detrermination:

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

Updated: 7/18/2007