The IRS frequently disallows deductions for activities it believes are “not engaged in for profit.” “Hobby Losses”, as the IRS calls them, often involve expenses for horse or dog breeding activities, small scale farming, small livestock operations, airplanes, etc. Because these businesses often grow out of hobbies, they tend to be started without adequate business planning and advice. For some, a business plan and other business like activities established at the outset of the business can make the difference between an activity that is engaged for profit and one the IRS determines is not. The attorneys and Anderson & Jahde represent businesses in “Hobby Loss” audits and litigation and they can help new business owners understand and implement procedures to help demonstrate that a new business is engaged in with the requisite profit motive.
Hobby Loss Definition
A hobby loss is a non-deductible loss from an activity done for personal pleasure and not for profit. Taxpayers cannot deduct a hobby loss as a business loss. To determine whether or not an activity is to be classified as a hobby or as a business, the hobby loss rule is applied.
To see how the hobby loss rule is applied, we can look at the case of Dirkse v. Commissioner, which was tried by Anderson and Jahde’s Nicholas J. Richards, Esq. during his time with the IRS. In this particularly case, the petitioners argued that losses from their beekeeping, tree-farming and rental activities were to be deducted as business losses. In deciding whether or not the hobby loss rule was too be applied to the hobbies, the court ultimately ruled in favor of Attorney Richards. A summary of what that decision was based on follows.
What Differentiates a Business Loss From a Hobby Loss?
In the case of Dirkse v. Commissioner, the court ruled:
“The basic standard for determining whether an expense is deductible under sections 162 and 212 (and thus not subject to the limitations of section 183) is the following: a taxpayer must show that he or she engaged in or carried on the activity with an actual and honest objective of making a profit. (1) Although a reasonable expectation of profit is not required, the taxpayer’s profit objective must be bona fide. (2) While the focus of this test is on the subjective intent of the taxpayer, objective criteria may also be used. Independent Elec. Supply, Inc. v. Commissioner, supra. Section 1.183-2(b) Income Tax Regs. (3) sets forth a nonexclusive list of factors to be considered in determining whether an activity is engaged in or carried on for profit. These factors are:
1. Manner of Carrying on the Activity
“The fact that a taxpayer carries on an activity in a businesslike manner and maintains complete and accurate books and records may indicate that the activity was engaged in for profit. (4) Adapting new techniques and abandoning methods that are economically inefficient may also support the conclusion that the taxpayer possessed the requisite profit motive.” (5)
2. Expertise of Taxpayer or Advisers
“Preparation for an activity after conducting an extensive study or consultation with experts regarding the accepted business practices of the activity may indicate a profit motive where the taxpayer conducts the activity in accordance with such study or advice. (6) Conversely, a taxpayer’s failure to obtain expertise in the activity may indicate a lack of profit motive.” (7)
3. Time and Effort Expended in the Activity
“The fact that a taxpayer devotes much of his or her personal time and effort in carrying on an activity, particularly if the activity does not have substantial recreational aspects, may indicate a profit motive.” (8)
4. Expectation That Assets May Appreciate
“An expectation that assets used in the activity will appreciate may indicate a profit objective. (9) Accordingly, a profit motive may be inferred even where there are no operating profits, so long as the appreciation in value of the activity’s assets exceeds its operating expenses of the current year and its accumulated losses from prior years.” (10)
5. History of Income or Losses From the Activity
“A history of losses over an extended period of time may indicate the absence of a profit objective. (11) Although a long history of losses is an important criterion, it is not necessarily determinative. (12) For instance, a series of startup losses or losses sustained because of unforeseen circumstances beyond the taxpayer’s control may not indicate a lack of profit motive.” (13)
6. The Amount of Occasional Profits, Earned, If Any
“If an activity generates only small, infrequent profits and typically generates large losses, the taxpayer conducting the activity may not have a profit objective.” (14)
7. Taxpayer’s Financial Status
“Substantial income from sources other than the activity in question, particularly if the losses from the activity generate substantial tax benefits, may indicate that the activity is not engaged in for profit.” (15)
8. Elements of Personal Pleasure or Recreation
“The existence of recreational elements in an activity may indicate that the activity is not engaged in for profit; on the other hand, where an activity lacks any appeal other than profit, a profit motive may be indicated.” (16)
No single factor is necessarily relevant or dispositive; rather, the facts and circumstances of the case ultimately control. (17) Further, the determination of a taxpayer’s profit motive is made on a yearly basis. (18)
(1) See Antonines v. Commissioner [90-1 USTC ¶ 50,029], 893 F.2d 656, 659 (4th Cir. 1990), affg. [Dec. 45,094] 91 T.C. 686 (1988); Independent Elec. Supply, Inc. v. Commissioner [86-1 USTC ¶ 9192], 781 F.2d 724, 726 (9th Cir. 1986), affg. Lahr v. Commissioner [Dec. 41,467(M)], T.C. Memo. 1984-472;Ronnen v. Commissioner [Dec. 44,529], 90 T.C. 74, 91 (1988); sec. 1.183-2(a), Income Tax Regs.
(2) See Hulter v. Commissioner [Dec. 45,014], 91 T.C. 371, 393 (1988); Beck v. Commissioner[Dec. 42,436], 85 T.C. 557, 569 (1985).
(3) See Independent Elec. Supply, Inc. v. Commissioner, supra. Section 1.183-2(b)
(4) See Engdahl v. Commissioner [Dec. 36,167], 72 T.C. 659, 666 (1979); sec. 1.183-2(b)(1), Income Tax Regs.
(5) See Allen v. Commissioner [Dec. 35,977], 72 T.C. 28, 35 (1979).
(6) See sec. 1.183-2(b)(2), Income Tax Regs.
(7) See Burger v. Commissioner [87-1 USTC ¶ 9137], 809 F.2d 355, 359 (7th Cir. 1987), affg. [Dec. 42,428(M)] T.C. Memo. 1985-523.
(8) See sec. 1.183-2(b)(3), Income Tax Regs.
(9) See sec. 1.183-2(b)(4), Income Tax Regs.
(10) See Golanty v. Commissioner [Dec. 36,111], 72 T.C. 411, 427-428 (1979), affd. 647 F.2d 170 (9th Cir. 1981).
(11) See Allen v. Commissioner [Dec. 35,977], 72 T.C. at 34.
(12) See Engdahl v. Commissioner [Dec. 36,167], 72 T.C. at 669; Allen v. Commissioner, supra.
(13) See sec. 1.183-2(b)(6), Income Tax Regs.
(14) See Golanty v. Commissioner, supra at 427; sec. 1.183-2(b)(7), Income Tax Regs.
(15) See Hillman v. Commissioner, supra; sec. 1.183-2(b)(8), Income Tax Regs.
(16) See Hillman v. Commissioner, supra; sec. 1.183-2(b)(9), Income Tax Regs.
(17) See Keanini v. Commissioner [Dec. 46,354], 94 T.C. 41, 47 (1990).
(18) See Commissioner v. Sunnen [48-1 USTC ¶ 9230], 333 U.S. 591, 598 (1948).