The Treasury Inspector General for Tax Administration released a report that chided the IRS for losing more than $70 million by not correctly identifying hobby activities on Schedule Cs. The report found that of a sample of 100 returns, 88 of them were businesses not engaged in for profit (hobby activities). Will this report impact you? Understand the hobby loss rules to see whether you’re vulnerable to IRS scrutiny.
Tax implications of hobby activities
While all the income from such activities must be reported, losses are treated differently than business losses. Hobby losses:
- Are deductible only as miscellaneous itemized deductions on Schedule A. This means only amounts over 2% of adjusted gross income are actually deductible.
- Are not deductible if you are subject to the alternative minimum tax (miscellaneous itemized deductions can’t be taken for AMT purposes).
- Cannot generate a net operating loss, which allow unused current losses to be used in other years (i.e., hobby losses that aren’t deducted currently are lost forever).
What’s a hobby versus a business?
While companies of any size can lose money from time to time (just look at the recent reports from such giants as Gap and British Petroleum), a business is run with the intention of making a profit. A hobby activity lacks a profit motive.
How do you determine whether there’s a profit motive? There’s no bright line test, such as a certain amount of revenue. It’s a facts-and-circumstances test based on the following 9 (non-exclusive) factors:
- 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.
There’s a presumption that you have a profit motive if you show a profit in 3 out of 5 consecutive years (2 out of 7 years for horse activities). To rely on this presumption, you have to file Form 5213, but this action isn’t advisable in most cases. Filing the form avoids any IRS inquiries during the presumption period, it virtually guarantees that the IRS will audit you at the end of the presumption period.
Nature of the activity doesn’t make it a business or a hobby
Just because an activity may seem like a hobby, doesn’t make it one. Take the recent case of an immigrant who did hair braiding in addition to having a full-time job. The IRS said the hair braiding was a hobby, but the Tax Court agreed with her that it was a business and losses were deductible. While she may have been “unduly optimistic” about her ability to make a profit, she has a genuine profit motive when she opened her business. It failed because of the recession in 2008-2010 and other factors beyond her control.
Even if an activity appears to be solely for business, it doesn’t stop the IRS from challenging it. Take these examples:
- A young attorney had her law firm challenged as a hobby activity. The Tax Court agreed with her that it was run with the intention of making profit.
- An artist and tenured professor had her studio challenged as a hobby activity. The Tax Court sided with her.
If you have multiple activities, can they be aggregated for determining a profit motive? The answer is: in some cases, yes. Take the case of Peter Morton, the founder of the Hardrock Café and several other enterprises, who used a unified business theory to avoid the hobby loss limit on one of his activities (operating his Gulfstream Jet). The multiple undertakings have to be sufficiently interconnected for this to work, and his were.
In light of the TIGTA’s report, expect the IRS to be more vigilant about examining returns that show losses on Schedule C. If you run an activity that could be questioned as a hobby, make sure you’re running it in a businesslike fashion, keeping good records, and trying to improve profitability. Consider whether aggregating it with your other activities makes sense. And talk to a tax advisor if you have any questions about the hobby loss rules.
NOTE: This article was originally authored by Barbara Weltman and is republished with permission.