Hobby loss tax rules of IRC § 183 are nothing new. However, there are a couple of recent developments that make the application of those rules especially relevant:
- Starting in 2018, the Tax Cuts and Jobs Act (“TCJA”) went into effect. Under the TCJA, taxpayers lost the ability to take miscellaneous itemized deductions. Previously, taxpayers who itemized could deduct the expenses of any income generating “hobby” up to the income generated by the activity (subject to the 2% floor on miscellaneous itemized deductions). Now, with the elimination of miscellaneous itemized deductions and doubling of the standard deduction meaning less taxpayers itemize anyway, expenses of any such activity are no longer deductible. These income-generating “hobbies” just became more expensive. Previously, I wrote about related issues to describe the heightened importance of being a “trade or business” after the TCJA.[1]
- During the COVID-19 pandemic, many taxpayers sought supplemental sources of income. That may be due to a job loss, reduction of income, extra time working from home, or other reasons. Often, individuals look to their hobbies to generate income. For example, someone who has had a hobby of making crafts, may dedicate more time to craft making and look to sell their work. If that has traditionally been a hobby, not generating a profit, done from home, then it is quite possible the craft making activity will be viewed as a hobby by the IRS to disallow deductions for expenses incurred in the craft making activity.
Yet another reason to carefully consider planning for potential hobby loss cases is suggested in a recent New York Time article.[2] This article rightly identifies that the large tax gap (the amount of tax Americans owe versus what is collected) and notes that president-elect Biden could satisfy his pledge to collect more taxes from high income taxpayers by merely increasing enforcement aside from any law changes. This may allow Biden to fund many of his priorities without Congress agreeing to his proposed tax changes. Rather, he would raise the revenue through enforcement. Should increased enforcement become part of a Biden administration’s playbook, taxpayers will need to be more careful in structuring their affairs. While we never advise clients to play the “audit lottery,” plenty of taxpayers effectively get away with tax reporting that would not be sustained on audit merely as a result of the meager IRS budget. If the IRS enforcement budget is increased, then more taxpayers are at risk if they do not properly structure their affairs.
Anyone looking to benefit from tax losses or expenses arising from an activity which may appear to be a hobby or otherwise have personal or recreational aspects should be careful in how they structure their affairs. The hobby loss rules and the definition of a “trade or business” under IRC § 162 for income tax purposes are different. Hobby loss rules look for a “profit motive” and, in determining whether a “trade or business” exists, tax law also looks to determine whether the activity is undertaken with “continuity and regularity.”[3] However, both questions are subjective and have overlapping analysis.
Is the Activity a Hobby or Undertaken with a Profit Motive?
In determining whether a profit motive exists, the regulations provide that the “a reasonable expectation of profit is not required.”[4] Rather, the taxpayer’s objective intent is at issue, not the reasonableness of that intent.[5] Subject to a presumed profit motive, if the activity generates net income for three of the past five consecutive years[6], the facts and circumstances, taken as a whole, determine the outcome.[7] In reviewing the facts and circumstances, the regulations set forth nine factors, none of which is fully determinative:
- manner in which the taxpayer carries on the activity (i.e. is it carried on in a “business-like manner?”);
- expertise of the taxpayer and his advisors;
- time and effort expended by the taxpayer in carrying on the activity, especially where there are no “substantial personal or recreational aspects;”
- expectation that assets used in the activity may appreciate in value;
- success of the taxpayer in carrying on other similar or dissimilar activities;
- taxpayer’s history of income or losses with respect to the activity, which can be strong indicator of a profit motive if there is a series of years in which net income was realized;
- the amount of occasional profits, if any, which are earned, especially in relation to the amount of losses incurred;
- financial status of the taxpayer; and
- elements of personal pleasure or recreation.[8]
In cases where IRC § 183 is at issue, it is common for the Tax Court to analyze these factors one-by-one.[9] Once the court conducts this analysis, it renders an opinion as to whether the taxpayer held the requisite objective profit motive. This is a threshold question to allowing deduction of losses against other sources of income.
Of course, the facts which support a conclusion under these factors are developed by the IRS in an audit. The IRS has published an Audit Technique Guide which outlines how a revenue agent or tax compliance officer should conduct an audit with respect to issues relating to IRC § 183.[10] That guide outlines how the IRS may conduct the exam including a document request, in-person interview, and tour of the business location.
Planning for a Successful Outcome
Certainly, any activity that looks like a typical hobby for which a taxpayer is seeking to deduct expenses may give rise to IRS scrutiny. How a taxpayer’s individual facts and circumstances favor a finding that profit motive exists determine the outcome of the IRC § 183 analysis. To that end, anyone seeking to deduct expenses from any such business should carefully look to the nine factors cited above.
Appendices to the IRS Audit Technique Guide walk through the nine factors, a sample set of interview questions to ask a taxpayer, and a sample document request. A detailed description of these items is beyond the scope of this writing. However, anyone looking to deduct expenses from any activity which may have the characteristics of a hobby would be well advised to review these materials.
After a review of the nine relevant factors and the IRS Audit Technique Guide, there may be certain variables which cannot be controlled. For example, the taxpayer may not have a history with the activity. It may be a new venture. As such, this factor is something the taxpayer cannot control. However, the taxpayer can control many of the variables, which is especially important when converting a former hobby into a profit-seeking venture. A clear change in the conduct of the activity should occur. For example, the taxpayer should create a business plan, maintain businesslike records, seek expert advice, maintain the appearance of a viable business (such as business cards, website, separate telephone number, dedicated workspace, etc.), and undertake other steps to clearly differentiate a hobby from a business.
There have been at least a couple of recent taxpayer victories in this area. We previously have written about the Den Besten case.[11] That writing walks through the court’s analysis of the factors. Another taxpayer victory was in the WP Realty case.[12] In each of these cases, activities may have been viewed as a hobby (horse cutting and golfing operations). However, when walking through the factors, the taxpayer was able to illustrate a profit motive from the facts and circumstances present. This can be contrasted from several other cases (see Footnote 9 for some recent cases) where taxpayers were not successful. Often, in reviewing the analysis, the result comes down to an overriding look of operating as a business versus a personal activity. While there may be a number of factors at issue, this predominate appearance cuts across many of the factors. As a result, especially when there is an activity which may have hobby-like characteristics, taxpayers should operate that activity in as businesslike fashion as is reasonable under the circumstances and be prepared for an IRS exam which will include the above-referenced analysis including a business tour.
Conclusion
Especially considering the current pandemic, many individuals may look for new sources of income. For several people, that may mean seeking to turn a historic hobby into a profitable business. The regulations, IRS Audit Technique Guide, and Tax Court opinions give us plenty of material to review in making sure the facts will support deductions relating to those activities. When an activity may appear to be a hobby, it is important to review these materials. It may be possible to structure the activity to more clearly establish facts analyzed by the IRS and Tax Court as supporting a profit motive. Failure to do so could lead to an analysis inconsistent with the taxpayer’s subjective intent. Anyone seeking to establish objective criteria to support their subjective profit-making intent should seek proper tax advice.
[1] Edmondson, Gray, “The Importance of Being a ‘Trade or Business’,” Sept. 12, 2018, https://esapllc.com/the-importance-of-being-a-trade-or-business/
[2] Irwin, Neil, “There’s a Way Biden Can Raise More from the Rich without Higher Taxes,” Dec. 22, 2020, https://www.nytimes.com/2020/12/22/upshot/biden-taxes-irs.html?searchResultPosition=1
[3] See Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987)
[4] Treas. Reg. § 1.183-2(a)
[5] Id.
[6] IRC § 183(d)
[7] Treas. Reg. § 1.183-2(a)
[8] Treas. Reg. § 1.183-2(b)
[9] For a handful of recent cases, see Den Besten, TC Memo 2019-154; Sarkin, TC Memo 2019-131; WP Realty, LP, TC Memo 2019-120; McMillan, TC Memo 2019-108; Sapoznik, TC Memo 2019-77; Donoghue, TC Memo 2019-71; Steiner, TC Memo 2019-25; and Kurdziel, TC Memo 2019-20
[10] https://www.irs.gov/pub/irs-utl/irc183activitiesnotengagedinforprofit.pdf
[11] Sage, Joshua W., “Another Horse Case, Pro Se Petitioner, and Reasonably Scaling Back Being Indicative of a Profit Motive,” Dec. 17, 2019, https://esapllc.com/besten2019/
[12] WP Realty, LP, TC Memo 2019-120
