Originally published on Forbes.com.
Tax advisers are too conservative in claiming business losses for activities that seem to smack of being hobby loss cases and writers like me are partially to blame. That is my conclusion from a deep dive into studying decisions about Section 183 – Activities not engaged in for profit –
Don’t blame your adviser if he or she has been a stick in the mud about claiming losses for your yacht chartering or horse breeding or that strange machine you are building in your backyard. There is sound thinking behind being cautious in the area.
Nonetheless, I believe that many advisers have been too cautious. Although this is written to my fellow advisers, it won’t be too technical for you to follow along if you prefer to be your own tax adviser.
Survey Says
After coming up for air, I did a poll on TaxTwitter
Your client has long string of losses from activity (e.g. horse breeding) where profits seem improbable. Should you tell client not to claim the losses?
Of course, the correct answer is “It depends”, but I did not have that as an option. I was looking for the initial gut feel and it came out. Don’t claim – 58% Claim 42%. OK so it was only 45 total votes, but it supports my impression so I will stick with it.
I used to lean negative on the issue too, but I think I was wrong. If your client comes to you indicating that they are entering into a venture which you see as having the makings of a hobby loss deduction, start from the assumption of taking the losses and then go into how it depends.
First, let’s look at why advisers tend towards the negative in the hobby loss area.
It Seems Like They Are Usually Losing
I am coming up on ten years of tax blogging. I basically write about developments that I find interesting. Although I will cover some things because of the larger issues that are involved – like the interaction of religion and tax, I mainly go for great stories and practical observations. Hobby loss cases are great on both grounds.
There was the guy who was breeding the mutant deer and the kid who was doing a travel blog, which included observations about drugs and prostitutes, and the professor who had to go to France to write about the wines of New Jersey.
My impression was that the taxpayers usually lost the cases. My research so far has confirmed that result. I have reviewed 265 decisions. I can’t rule out that I somehow overlooked something but included, I believe, in my 265 decisions are all the appellate decisions, all the district court decisions, all the Court of Claims, all the Tax Court Regular decisions and a smattering of the Tax Court Memorandum decisions that concern Section 183. The TCM decisions are ones within the last five years and earlier decisions that are cited in recent decisions.
The IRS won the Section 183 issue in 196 decisions. The taxpayer won the issue in 69 decisions.
Anyway, there you have the source of the negativity. Odds in Section 183 cases are about three to one in favor of the IRS in the courts. But there are reasons to not form a planning conclusion from that observation. The IRS tends to settle a case, it does not feel sure about it. Taxpayers are often quite stubborn.
Even those odds are actually not that bad. Assume that the interest you pay on a tax deficiency represents a fair amount for the use of the money. You take an aggressive position on 183, even though you are certain that you will be examined. If your chance of prevailing on a $10,000 deficiency is 25%, the expected value of the aggressive position is $9,000 (The deficiency of $10,000 plus a $2,000 accuracy penalty times 75%).
Even The Losers Win
When writing about a hobby loss decision where the IRS prevailed, we will be telling about someone being tagged with a deficiency and almost inevitably an accuracy penalty of 20%. Let’s assume that the taxpayer asked somebody in year one of the activity whether he or she should claim the loss or just treat their hobby, as, you know, a hobby.
How long is it before they are challenged? For simplicity assume level tax losses of $50,000 and ignore the time value of money and go with a 40% tax rate. The taxpayer is audited for three years and loses. That’s a $60,000 deficiency, but of course if they had not claimed the losses at all they would have paid the $60,000. So they are even there. What puts them behind is the accuracy penalty of $12,000.
Now if the three years are the only years, they really are behind, but if the three years are the culmination of 15 years of losses being allowed they are way ahead. Probably the most extreme example of this principle is Louis Filios, whose Tax Court loss was confirmed by the First Circuit. The deficiency of over $325,000 for 1992 and 1993 had a $64,000 penalty tacked on.
1992 and 1993 capped off 37 years of allowed losses. He had been audited for 1977, 1980 and 1984 and there had been no Section 183 adjustment in those years.
I realize this smacks of audit lottery advice, which is unethical, but my assumption is that your client is sincere in that they are trying to make money. And that is what is required.
Honest Objective
Section 183 was enacted as part of the Tax Reform Act of 1969. Regulations were issued in 1972. They are mostly unchanged. One of the earlier people to run up against Section 183 was Maurice Dreicer. In 1979, the Tax Court upheld deficiencies totaling $30,000 for 1972 and 1973. (You could call that $180,000 in today’s dollars).
Mr. Dreicer’s “business” was traveling around the world and going to fine restaurants which would endeavor to serve him the”perfect steak”. He was planning a book titled My 27 Year Search for the Perfect Steak — Still Looking. He was already a published author with The Diner’s Companion.
Although it ended up not doing him any good Dreicer’s winning appeal to the DC Circuit set an important precedent.
We perceive no basis for disturbing the Tax Court’s finding on the nature of the undertakings generating the losses for which deductions are sought. We do not accept, however, the legal test that the court employed in ruling on deductibility. We hold that a taxpayer engages in an activity for profit, within the meaning of Section 183 and the implementing regulations, when profit is actually and honestly his objective though the prospect of achieving it may seem dim . Because the Tax Court applied a different standard, we reverse and remand for redetermination of Dreicer’s deduction claims. (Emphasis added)
The reason the victory in the First Circuit did not help Dreicer is that even under that standard, the Tax Court did not think he had an honest profit objective.
There Is More
This post is the beginning of a series. That means that there will be at least one more post. If your client with a straight face is telling you that he is really trying to make money with his treasure hunting, take him seriously.
Of course, it still depends, as they say, but you need to start from “Yes”, because what the law requires is an honest objective. If the honest objective is there and the right steps are taken, a Section 183 case is winnable, regardless of the nature of the activity – except maybe for being an Amway IBO, but I have already covered that.
In the next post, I will discuss the nine factors that are considered in evaluating Section 183 cases and explain why there is only one of them that matters.
By the way the Tax Court allowed Frederick Harrison’s treasure hunting losses in 1996.