Originally published on Forbes.com.
The Treasury Inspector General For Tax Administration (TIGTA) does not think the IRS has been aggressive enough in pursuing hobby loss cases. Section 183 “Activities not engaged in for profit” denies deductions in excess of gross income in the case of activities where there is no profit motive. Between some experience and the reading of a lot of cases, it seems that the IRS is pretty active in that area, so it is not real pleasing to think that they will be getting even more active. The TIGTA report might give us some hints about audit triggers, so it is worthwhile taking a look at it.
Background
There are nine factors that are used to distinguish between activities that are being run to make a profit as opposed to those that are started and continued just for the heck of it
- The manner in which the taxpayer carried on the activity,
- The expertise of the taxpayer or his or her 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 loss with respect to the activity,
- The amount of occasional profits, if any, which are earned,
- The financial status of the taxpayer, and
- Elements of personal pleasure or recreation.
In terms of your audit profile, it is pretty clear that factors seven and eight – occasional profits and financial status- are the most important. Revenue agents have the same education as accountants meaning that the things that count most are the things that you can count.
From Mutant Deer To Travel Blogging
The reason I dote on hobby loss cases is that the decisions tend to tell really interesting and frequently amusing stories. They also provide interesting insights into the various types of activities. Since I have started tax blogging I have covered hobby loss cases concerning musicians, photographers, genetically engineered deer (no kidding), artists, motocross racing, playing slot machines, cattle ranching, historical research, track coaching, airplane remanufacturing and yacht chartering by the great F. Lee Bailey, science fiction and drag racing. I did a comprehensive analysis of Amway cases. And then there are the horse cases, lots of those. I’ll bet you don’t know what a phantom mare is. Well, I didn’t till I read about it in a horse hobby loss case. Horse hobby loss was even an issue in the 2012 election campaign as Romney’s Rafalca was dancing in the Olympics. I even covered a case about a travel blogger, who went to some museums when not checking out the drugs and prostitutes.
A make or break factor in a lot of the cases was a written plan. In the very significant Susan Crile decision, that was softened a bit.
Although petitioner did not have a written business plan, she had a business plan and she pursued it consistently. Petitioner understood the general factors that affect the pricing of art —a history of sales, gallery representation, solo exhibits, positive critical reviews, and prestigious awards, fellowships, and residences. She then worked to enhance her credentials and professional stature in each of these respects, in an effort to increase the value of her art.
Still if you have anything that looks like a hobby loss on your return, have a written business plan and update it as circumstances change. The most important thing is that people who have year after year of losses will tend to lose the case if they don’t show that they alter their activities based on results. Don’t keep making the same mistakes over and over. Better to make new mistakes.
What Does A Hobby Loss Return Look Like?
This is the important insight from the TIGTA report. When they went looking for returns that they thought merited hobby loss examination. Here is what they looked at:
To determine the compliance rate with the tax law regarding hobby losses, we used data from the IRS’s Individual Return Transaction File and Individual Master File to identify 9,699 individual returns for TY 2013 with wages of $100,000 or more that also contained a Schedule C with gross receipts of $20,000 or less and a loss of $20,000 or more. These taxpayers also reported losses in four consecutive years through TY 2013 for the same businesses. We used these criteria because the materiality of the taxable income offset would likely make these returns a high priority for IRS Examination resources.
Immediately thereafter, there is a redacted sentence.
I should make something clear here. The AICPA standards of tax practice forbid me from given audit lottery advice. I think sharing the above with you, though is not really audit lottery advice and actually you’re not my client. Here is the deal. Three or four years of losses on a side schedule C, when you have more than $100,000 in other income, be prepared with a story of how you will be making money in that enterprise in the future. Also, have good logs of the time you spend. Good time records (as opposed to “ballpark guestimates”) are important not only as the third factor in the hobby loss analysis but also because of the passive activity loss rules.
Cosmetic Factors
Apparently a dinky Schedule C is more suspicious than a loss flowing through from an S corporation or partnership. A lot of practitioners will advise you to put your enterprise in an entity for that purpose. I am hesitant to give that advice because then there is another return that might get audited. I have not been able to figure out how to balance those two factors.
There is an election that you can make to defer the determination of for-profit status- Form 5213 . There is a presumption that if you made money in three of the last five years (two of the last seven for a horse business) that you are trying to make money. You can get extra time on the determination, but it requires that the statute of limitations remain open longer. Frankly, I have never considered filing this form and don’t know anybody who has. I am allergic to statute extensions. I would appreciate hearing from anybody who thinks it is a good idea.
Giving Up Time For Money
If your little side business has posted losses in the first two years and year three is not looking so good, you may want to consider deferring deductions. One way you can do it is to consider yourself as not materially participating. Then your losses will be suspended, which hurts immediately. On the other hand, they will be available when the enterprise turns profitable or you finally abandon it. Back in the good old days of money earning interest, the deferral of losses would be a big negative, but not so much nowadays.
The other thing to consider is to not be so aggressive in expensing things, but rather lean towards capitalizing. The bottom line is even if it is painful to defer deductions it is much less painful than losing them entirely.
Something The FAIR Tax Will Not Fix
On almost any tax issue I write about I can count on the possibility of getting a comment from someone that if we just converted to a simpler consumption system, we wouldn’t have all these problems. As it happens the hobby loss issue is one commonly litigated issue that would actually become even more common if the FAIR tax were implemented. (The FAIR tax is the main contender for a consumption-based system at this point. It regularly gets proposed in Congress.)
Section 102(a)(1) of the “Fair Tax Act of 2015” reads:
BUSINESS AND EXPORT PURPOSES.—No tax shall be imposed under section 101 on any taxable property or service purchased for a business purpose in a trade or business.
I’m sorry to say this, but there are people out there that will never buy anything that costs more than a hundred dollars that will not argue that the item is for business or investment (also exempt) purposes. So even under the FAIR tax, hobby loss will still be an issue.
Preparers Be Alert
I interviewed Thomas Gullion a couple of years ago. He was a musician who won his hobby loss case pro se. Quite an accomplishment. I was really shocked when he told me that his tax preparer had not warned him about his hobby loss exposure. It may be that you want to spare your client’s feelings because they are passionate about the profit potential of their venture. Just tell them that their returns are looked at by boring stick in the mud accountants who have no vision and after three years of losses they best get their ducks in a row.