The Internal Revenue Service regularly challenges businesses that are found to generate losses and do not have a profit intent. The specific statute that governs these challenges are known as the “Hobby Loss Rules.” In such challenges, the Internal Revenue Service is trying to prove that the undertaking which has resulted in losses over a prolonged period of time is not profit-driven and is simply a hobby of the taxpayer, not a business engaged in for profit.
Historically, taxpayers were able to deduct hobby expenses up to the amount of income produced by the hobby. Expenses that were more than the income made from the hobby were generally nondeductible personal losses. These hobby expenses were limited as they were deductible only as miscellaneous deductions on a taxpayer’s Schedule A, Itemized Deductions.
The tax law is more stringent after the Tax Cuts and Jobs Act signed by the President on December 22, 2017. As that law repealed all miscellaneous deductions, a successful challenge by the Internal Revenue Service that a taxpayer’s activity is a hobby means that the hobby income will be reported on the tax return, but that no expenses of any kind will be able to be offset that income.
In contrast, if a taxpayer does operate a business, the business losses can offset other income on that taxpayer’s return. To be considered a business, an activity must have a profit motive. Thus, the challenges from the Internal Revenue Service are intended to disallow hobby losses from offsetting other sources of taxable income.
In a recent case, David Williams, TC Memo 2018-48 (Tax Ct.), the Internal Revenue Service found that a taxpayer’s ranching activities did not constitute a trade or business, but rather a hobby.
A synopsis of the case:
The taxpayer owned a profitable research and publishing business. Through his limited partnership, the taxpayer acquired a ranch. After talking to his neighbors, he decided to run a feeder stocker cattle operation on the property. Although he kept books and records for the operation, the taxpayer never created a formal business plan, consulted with experts in the field of raising cattle, or checked with the county to determine how many animals could be sustained on the property.
For the years at issue, the taxpayer reported substantial losses from the cattle operation on his Schedules F. The Internal Revenue Service disallowed the losses, claiming that the ranching activities were not engaged in for profit within the meaning of Internal Revenue Code §183 (i.e., the Hobby Loss Rules).
In this decision, the Tax Court agreed, holding that the taxpayer lacked the requisite profit motive. Therefore, the hobby loss rules applied.
The key to successfully defending against an Internal Revenue Service challenge in this area is to produce an ongoing taxable profit in the business. The Internal Revenue Service presumes that the activity is carried on for profit if one of the following applies:
- It makes a profit in at least three (3) of the last five (5) years.
- It makes a profit in at least two (2) of the last seven (7) years, and the activity is mainly one of the following:
- Breeding horses
- Showing horses
- Training horses
- Racing horses
Further proof that the activity is a trade or business engaged in for profit is manifested in the way the activity is managed and operated. It is extremely helpful in such instances if the activity is managed and operated in a “business-like manner.” To that end, the Internal Revenue Service considers many factors when deciding if the activity is a business or a hobby. No one item is the deciding factor, and the Internal Revenue Service might consider factors not listed. Deciding factors can include:
- Manner in which the taxpayer carries on the activity
- The taxpayer and his or her advisor’s expertise
- Time and effort the taxpayer puts into carrying out the activity
- The taxpayer’s expectation that assets used in the activity might appreciate in value
- The taxpayer’s success in carrying on similar or dissimilar activities
- The taxpayer’s history of income or losses with respect to the activity
- The amount of occasional profits, if any, that are earned
- The taxpayer’s financial status
- Elements of personal pleasure or recreation the activity has for the taxpayer
With the changes to the law made by the Tax Cuts and Jobs Act, preventing a successful challenge to a business activity conducted by a taxpayer and having it reclassified as a hobby is more critical than ever. If you have questions or concerns regarding the business activity that you are conducting, please contact Bob Grossman or Don Johnston at 412-338-9300.