The Internal Revenue Code limits the deductions that a taxpayer can take for activities not engaged in for profit. 26 U.S.C. §183(c) defines “activity not engaged in for profit” as any activity other than those that deductions are allowable under 26 U.S.C. §162 (“trade or business”) or 26 U.S.C. §212 (“investments”). Known as the “hobby loss rule”, the purpose of these laws is to prevent taxpayers from reducing their overall tax liability on legitimate business income by claiming excessive and abusive expenses from hobbies or side businesses not intended to be profitable.
As an example, a taxpayer reports on his Form 1040 Schedule C the income and expenses from his sole-proprietor plumbing business. That same taxpayer also reports on the same Schedule C the income and expenses from the yoga class he teaches on the side. While the plumbing business is the full-time occupation, the yoga class he teaches is a part-time recreational activity. The plumbing business is profitable and claims $50,000.00 after expenses, but the yoga class only draws in revenue of $5,000.00 and incurs expenses of $6,000.00 in rental costs and $12,000.00 in advertising (a net loss of $13,000.00). If the yoga class was treated as a trade or business, then he could deduct the full loss against his plumbing business and pay taxes on an income of $37,000.00 instead of $50,000.00. If the taxpayer had several other “side businesses” where expenses exceeded revenue, he could possibly push his taxable income to nothing. The potential for abuse by utilizing several money-losing hobbies to eliminate taxable income is great.
To curtail this, 26 U.S.C. §183(b)(2) provides that a taxpayer may deduct an amount “equal to the amount of the deductions which would be allowable … only if such activity were engaged in for profit, but only to the extent that the gross income derived from such activity for the taxable year exceeds the deductions allowable…”. This provision limits the deduction for expenses from a hobby activity to the amount equal to the gross income generated by that same activity. This amount is not aggregated among all hobbies (e.g. the taxpayer can only deduct yoga class expenses to the extent of yoga class revenue and likewise can only deduct knitting expenses to the extent of knitting income, but the non-deductible yoga and knitting expenses cannot be utilized against other hobbies). There are a few exceptions to the hobby loss rules (e.g., the deduction of certain taxes under 26 U.S.C. §164), but they are few and far between to prevent abuse.
So when is an activity considered a business and when is it considered a hobby? Deductions are allowed as a trade or business or an investment if the taxpayer engaged in the activity “with the actual and honest objective of making a profit.” The taxpayer does not need to establish that his or her expectation of profit was reasonable, but the profit objective must be determined based on all the facts and circumstances. Section 1.183-2(b) of the Income Tax Treasury Regulations lays out a non-exhaustive of facts heavily relied upon by the U.S. Tax Court to decide whether the activity is either a hobby or a business:
- The manner in which the taxpayer carries on the activity;
- The expertise of the taxpayer or his advisers;
- The time and effort expended by the taxpayer in carrying on the activity;
- The expectation that the assets used in the 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; and
- Any elements indicating personal pleasure or recreation.
Fortunately, 26 U.S.C. §183(d) allows for a presumption that the taxpayer is engaged in an activity for profit if, in 3 out of 5 consecutive years (or 2 out of 7 consecutive years if the activity is breeding, training, showing or racing horses), the activity derives ANY profit. Further, 26 U.S.C. §183(e) allows a taxpayer to elect to postpone a determination of whether this presumption applies until after the 4th year of the activity (6th year if breeding, training, showing or racing horses) by filing Form 5213. Generally, this election is raised by taxpayers when the IRS initiates an audit to disallow the deductions from the activity. The taxpayer’s election can postpone the auditor’s decision, BUT it automatically extends the normal 3-year statute of limitations for the IRS to assess any additional taxes.
The Internal Revenue Service tends to audit those hobby-like activities that attract very large expenses against substantial income. For example, activities of the wealthy such as airplane charter flights, ranching or causal business consulting are frequent targets of the IRS for examination. In particular, the Internal Revenue Service has a high success rate in declaring horse breeding or horsing racing activites as a hobby where the activity is not a full-time occupation of the taxpayer, the history of profitability is lacking, the taxpayer makes his fortune elsewhere, and the activity overall tends to be a largely recreational to those involved.
How can a taxpayer avoid this “hobby loss” classification? First and foremost, run your hobby like it was a business. Maintain a separate bank account from your personal finances, store the inventory in a structure different from your home, and dedicate a substantial amount of time to the activity with an eye to generating profits. Excessive commingling with your personal assets gives the “side business” the trapping of being a leisure activity that is engaged in only at your sole convenience. There is no single factor that dominates over any other in deciding whether the pursuit is a business or a hobby. The IRS and the courts will determine this classification from the overall picture.
The following is a sample of U.S. Tax Court cases where the IRS sought to classify a claimed for-profit activity of the taxpayer as a hobby:
- Bailey v. Commissioner, T.C. Memo 2012-96 (April 2, 2012) – The Tax Court found that attorney F. Lee Bailey’s wholly owned S-Corporation that managed a yacht rental business was an activity not engaged in for profit. This opinion was supported by findings that Mr. Bailey did not keep records, did not change or alter his business operations despite his losses, he had no prior experience in yacht rental, he spent little time on refurbishing the single yacht he had or developing a plan to sell other yachts, he derived substantial income from the law practice where he spent most of his time, had no expectation that the yacht would increase in value, and primarily used his yacht for personal pleasure. As a result, his “business” was declared a hobby and all expenses that exceeded the revenue from his yacht rental business was disallowed.
- Roberts v. Commissioner, CA7, No. 15-3396 (April 15th, 2016) – The Seventh Circuit Court of Appeals reversed the U.S. Tax Court’s determination that the petitioner’s horse-racing enterprise was a hobby, not a business. In support of the contention that it was a business, the Court found that the petitioner made a large land purchase and improvements to his facility in 2005 at significant cost, significantly reduced his involvement in his previous businesses around the same time, and that he engaged in legislative lobbying designed to increase the profitability of horse racing. The IRS assessment came in 2008 (only three years after the purchase and improvements), when the history of large losses were considered part of the unforeseen expenses normally incurred during the “start-up” phase. Furthermore, the petitioner conducted his operation in a business-like way, extensively studied to obtain a training license, and that he actually realized occasional profit from winning purses on his horse races. The fact that the petitioner derived personal pleasure from engaging in horse racing is not sufficient to cause the activity to be classified as a hobby in light of the other factors.
- Hess v. Commissioner, T.C. Summary Opinion 2016-27 (June 20th, 2016) – Petitioners were independent distributors for Amway, a supplier of household, health and cosmetic products, and they reported losses on their Schedule C year after year. The Tax Court found in favor of the IRS in that the petitioners operated a Section 183 activity. It determined that the petitioners did not operate their business in a business-like manner (e.g., did not create a ledger, profit and loss statements, or improve the performance of their activity), had no prior experience in independent distributorship, did not keep records of distributors they enlisted as members of their “downline” distribution, never generated a profit, that both petitioners had full-time employment in other industries, and that both petitioners bought and used Amway products for personal consumption and pleasure.
- Welch v. Commissioner, T.C. Memo 2017-229 (November 20th, 2017) – Petitioners operated a “mulitoperational, 8,700-acre ranch with 25 full-time employees…” and operated in cattle, hay and horses. The Tax Court found that the Petitioners operated a trade or business. This opinion was supported by evidence that the ranch was maintained in a businesslike manner (separate books tracked incomes and expenses), changes in activities were made when petitioners determined they were not profitable, the petitioners were extensively educated in agriculture, the petitioners spent three days per week at the ranch, and the ranch’s business assets were appreciable. Although the ranch had no profit and continued losses, the Court determined that petitioners were still in the “start-up” phase so the large, unexpected losses were understandable.
- Robison v. Commissioner, T.C. Memo 2018-88 (June 19th, 2018) – Petitioner, a retired physical therapist, purchased and operated a 410-acre ranch in Utah that employed a ranch manager and ranch hand but never turned a profit. The Tax Court found in favor of the IRS in that the petitioners operated a Section 183 activity. The Court relied on the history of losses over 16 years that seemed to indicate a lack of profit motive and that the petitioner had substantial income from other sources.
If you have questions about whether your activity should be considered a business or a hobby for federal income tax purposes, do not hesitate to contact the tax professionals at Kershaw, Vititoe & Jedinak PLC.