Small Business Taxes & ManagementTM--Copyright 2023, A/N Group, Inc.
We've had a number of questions from readers regarding the "hobby loss" rules. The discussion below is intended to give you an insight into the general rules as well as some related issues.
3 out of 5 Rule
Many taxpayers are aware of the 3 out of 5 rule. More than a few believe if you show a profit in 3 out of the past 5 consecutive years, your troubles are over. Fail that test and the losses aren't deductible. It's more complicated than that. First, passing the test only generates a rebuttable presumption that the activity is engaged in with a profit motive. Basically, that means the burden of proof is now on the IRS to show you don't have a profit motive. While that makes the Service's job harder, they can still try to deny you the losses. In addition, showing nominal profits for the three years while taking large losses for the other two won't put you in a good position if the IRS decides to press its case.
Second, just because you fail the test doesn't mean you can't take the losses. It means that the burden of proof is on you to show that you intended to show a profit. The IRS and the courts look at a number of factors to ascertain if you had a profit objective. (See below for a discussion of the factors.)
Third, you can make an election to postpone the determination whether the presumption described above applies with respect to an activity until after the close of the fourth taxable year following the taxable year in which the you first engage in the activity. You make the election on Form 5213, Election to Postpone Determination as to Whether the Presumption Applies that an Activity is Engaged in for Profit. The form must be filed within 3 years after the due date of your return (without extensions) for the year you first engage in the activity, but not later than 60 days after you receive a written notice from the IRS that it proposes to disallow deductions related to the activity.
Finally, in the case of an activity of breeding, training, showing, or racing horses, the 3 out of 5 rule is a 2 years out of 7 rule.
The regulations spell out nine factors that should be examined in determining if an activity is engaged in for profit. These are the factors the IRS and the courts look at. All facts and circumstances with respect to the activity are to be taken into account. No one factor is determinative in making this determination. In addition, it is not intended that only the factors described below are to be taken into account in making the determination, or that a determination is to be made on the basis that the number of factors indicating a lack of profit objective exceeds the number of factors indicating a profit objective, or vice versa. In other words, the IRS and courts can cherry pick and weigh factors. For example, assume the court looks at 9 factors. Six of those are in your favor; three for the IRS. The court determines that one of the factors in the IRS's favor should carry much more weight. The court could rule for the IRS. Among the factors which are normally taken into account are:
1. Manner in which the taxpayer carries on the activity. The fact that the taxpayer carries on a activity in a businesslike manner and maintains complete and accurate books and records may indicate that the activity is engaged in for profit. Similarly, where an activity is carried on in a manner substantially similar to other activities of the same nature which are profitable, a profit motive may be indicated. A change of operating methods, adoption of new techniques or abandonment of unprofitable methods in a manner consistent with an intent to improve profitability may also indicate a profit motive.
Most taxpayers fail to keep accurate books and records. Without these you can't know how the business is doing and you can't improve profitability. Based on the cases, good recordkeeping will go a very long way in impressing the court. That's one of the most often cited issues the courts consider. Modifying your business plan to improve profitability is also critically important. This is where most cases are lost. In fact, if you can't document your losses the court can (and has) stopped the case right there.
2. The expertise of the taxpayer or his advisors. Preparation for the activity by extensive study of its accepted business, economic, and scientific practices, or consultation with those who are experts in the field, may indicate a profit motive where the taxpayer carries on the activity in accordance with such practices. Where a taxpayer has such preparation or procures such expert advice, but does not carry on the activity in accordance with such practices, a lack of intent to derive profit may be indicated unless it appears that the taxpayer is attempting to develop new or superior techniques which may result in profits from the activity.
The courts often look first at the expertise of the taxpayer. For example, someone who has spent considerable time in various retailing operations has a better chance of succeeding at selling on the web. That's the best situation. In one case the court gave this factor to the taxpayer with a farming operation where he and his wife had been brought up on farms despite their current jobs as professionals. If you have little or no expertise in the field but consult experts such as a CPA, marketing professional, engineer, etc. your position is improved. The further afield the activity from your base knowledge, the more you should consult experts.
3. The time and effort expended by the taxpayer in carrying on the activity. The fact that the taxpayer devotes much of his personal time and effort to carrying on an activity, particularly if the activity does not have substantial personal or recreational aspects, may indicate an intention to derive a profit. A taxpayer's withdrawal from another occupation to devote most of his energies to the activity may also be evidence that the activity is engaged in for profit. The fact that the taxpayer devotes a limited amount of time to an activity does not necessarily indicate a lack of profit motive where the taxpayer employs competent and qualified persons to carry on the activity.
A casual interest in the activity, or an interest because of a related motive (farming because you want to get away from the city, horse breeding because your daughter wants to ride), doesn't bode well. Keeping a log of the amount of time spent on the activity and the work performed can be very helpful.
But you don't have to be engaged in the activity full-time to win, it just could be more difficult. And some taxpayers have won their case with little participation. One taxpayer had a professional ranch manager handling a cattle ranch and just acted as a general manager, very hands off.
4. Expectation that assets used in activity may appreciate in value. The term "profit" encompasses appreciation in the value of assets, such as land or buildings, used in the activity. Thus, the taxpayer may intend to derive a profit from the operation of the activity, and may also intend that, even if there's no profit from current operations, an overall profit will result when appreciation in the value of land is realized.
For example, you purchase a tract of land in the suburbs and run a small amusement park. You quickly discover it's difficult for the amusement park to turn consistent profits, the land is appreciating rapidly, allowing an overall profit from the activity. Caution. Special rules apply when you operate a farm. And this is often not a strong argument.
5. The success of the taxpayer in carrying on other similar or dissimilar activities. The fact that the taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable enterprises may indicate that he is engaged in the present activity for profit, even though the activity is currently unprofitable. Some individuals are serial entrepreneurs. They've started more than one business with most of them successful. If that's your situation you've got a good argument. If you have experience in that field or industry, you're on even firmer ground.
6. The taxpayer's history of income or losses with respect to the activity. A series of losses during the initial or start-up stage of an activity may not necessarily be an indication that the activity is not engaged in for profit. However, where losses continue to be sustained beyond the period which customarily is necessary to bring the operation to profitable status such continued losses, if not explainable, as due to customary business risks or reverses, may be indicative that the activity is not being engaged in for profit. If losses are sustained because of unforeseen circumstances which are beyond the control of the taxpayer, such as drought, disease, fire, theft, weather damages, other involuntary conversions, or depressed market conditions, such losses would not be an indication that the activity is not engaged in for profit. A series of years in which net income was realized would of course be strong evidence that the activity is engaged in for profit.
It's not unusual for the courts to consider the type of activity when viewing start-ups. For example, a common service business such as lawn maintenance, tutoring, etc. shouldn't take long to become profitable. On the other hand, a manufacturing business with a heavy investment in equipment and rent and a significant overhead that's developing a new product could naturally take longer to become profitable.
The courts have also recognized the unique situation of artists, writers, musicians, etc. They could be pursuing their craft for many years with little or no profits.
The courts have considered unforseen events such as a hurricane destroying the property or the local market, a drought, and, recently, the pandemic.
7. The amount of occasional profits, if any, which are earned. The amount of profits in relation to the amount of losses incurred, and in relation to the amount of the taxpayer's investment and the value of the assets used in the activity, may provide useful criteria in determining the taxpayer's intent. An occasional small profit from an activity generating large losses, or from an activity in which the taxpayer has made a large investment, would not generally be determinative that the activity is engaged in for profit. However, substantial profit, though only occasional, would generally be indicative that an activity is engaged in for profit, where the investment or losses are comparatively small. Moreover, an opportunity to earn a substantial ultimate profit in a highly speculative venture is ordinarily sufficient to indicate that the activity is engaged in for profit even though losses or only occasional small profits are actually generated.
8. The financial status of the taxpayer. The fact that the taxpayer does not have substantial income or capital from sources other than the activity may indicate that an activity is engaged in for profit. Substantial income from sources other than the activity (particularly if the losses from the activity generate substantial tax benefits) may indicate that the activity is not engaged in for profit especially if there are personal or recreational elements involved.
9. Elements of personal pleasure or recreation. The presence of personal motives in carrying on of an activity may indicate that the activity is not engaged in for profit, especially where there are recreational or personal elements involved. On the other hand, a profit motivation may be indicated where an activity lacks any appeal other than profit. It is not, however, necessary that an activity be engaged in with the exclusive intention of deriving a profit or with the intention of maximizing profits. For example, the availability of other investments which would yield a higher return, or which would be more likely to be profitable, is not evidence that an activity is not engaged in for profit. An activity will not be treated as not engaged in for profit merely because the taxpayer has purposes or motivations other than solely to make a profit. Also, the fact that the taxpayer derives personal pleasure from engaging in the activity is not sufficient to cause the activity to be classified as not engaged in for profit if other factors should a profit objective.
In some cases, particularly those involving artists, writers, etc. the courts have given less weight to factors 8 and 9, above, and more to 1, 2, and 3.
While enjoying the activity is rarely a critical factor by itself, it's often a tip-off. For example, listing auto racing, yacht chartering, modeling, antique dealer, etc. as the type business on a Schedule C or other business tax return could generate questions by itself. The flag will be higher on the pole if you have substantial income from other sources and this activity would offset that income.
Facts and circumstances. The outcome in many areas of taxes is based on facts and circumstances. That's true here. If your deduction is challenged and your out is not obvious, you'll need someone who's well versed in the are or willing to do his or her homework.
While most taxpayers assume the hobby loss rules (the actual name of the code section is "Activities Not Engaged in for Profit") only apply to sole proprietorships, that's not true. They apply to any business--S corporations, LLCs, partnerships, trusts, etc. Only regular (C) corporations are truly immune. The rules can also apply to rental properties, such as the rental of a second home.
In the case of a rental property you could run afoul of the hobby loss rules if you rent the property to a relative at less than the fair rental amount. That's the IRS's most frequent argument in such situations. However, renting the property to nonrelatives at leass than market rent can also cause problems. Generally, when the property is rented to an unrelated party the IRS usually doesn't challenge the profit motive. Because of high interest and depreciation deduction along with other costs, rental properties can legitimately lose money for a number of years. In addition, you can also use the argument that you hope to profit from appreciation in the value of the property.
The rules also apply by activity. That means you can't combine two activities to have the losses from one offset the profits of another. For example, you've got an S corporation that rents heavy construction equipment and turns a regular profit. You put your 60-foot sailboat that you charter out with consistent losses in the S corporation. While the S corporation may generate a profit, the IRS can still claim the yacht charter is not engaged in for profit and disallow those losses. On the other hand, if the S corporation's primary business was as a marina, shipyard, or similar venture, it's more than likely the IRS would consider the yacht chartering to be combined with the other activity.
The rules are intended to disallow deductions for expenses. But they can also be important if you sell an asset for a loss you claim was used in a business. Losses on the sale of business property (e.g., vehicles, equipment) can generate a full deduction. Losses on nonbusiness assets may be deductible as a capital loss or may not be deductible at all.
Even if the IRS or courts rule that your activity is not for profit, that doesn't mean you lose all the deductions. The deductions are disallowed according to a 3-step approach. Expenses that would be deductible regardless of a business activity (taxes, interest) are deducted first. Next, expenses that would be deductible if the activity was engaged in for profit, but only if the deduction does not result in an adjustment to basis (e.g., depreciation, worthless debts, amortization) and only up to the gross income from the activity. Finally, amounts resulting in an adjustment to basis, but only up to the remaining income from the activity.
If you pass the hobby loss test, you're still subject to the passive activity rules. You may have to show you materially participated in the activity. This is most likely to be an issue if you're more like an investor. For example, you finance your daughter's professional motorcycle racing activities. Simply reviewing the books and offering some suggestions isn't material participation. If you're involvement is greater, such as working in the business as a manager, acting as a salesman, etc. the next step is to determine if you accumulate enough time. If the activity is essentially a one-man show, you meet the requirement if your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity or you participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year. If you think you might encounter such a situation, keep records of your time in a diary or log. For more information go to our page Material Participation. Keep in mind that even if the activity is a hobby, you have to report the income. Work on neighbors' cars as a sideline? You may not even have any expenses, but you still have to report any income you receive.
Example 1--Assume you have gross income of $5,000 from your dog breeding venture. Your expenses are $800 for taxes, and $4,700 for stud fees, food, vet bills, etc. and $500 for depreciation of equipment. Your deductions would be limited to $5,000--$800 for the taxes and $4,200 for the stud fees, leaving you with a net profit of zero.If there is personal use involved, you'll have to allocate the expenses. For example, if you charter your sailboat for 9 months of the year and use it for personal purposes for 3 months, you can only use 3/4 of the maintenance expenses, slip fees, etc.
Example 2--Assume the facts are the same as above, but the stud fees, food, etc. total only $3,900. Your deductions would be limited to $5,000--$800 for taxes, $3,900 for fees, food, etc. and $300 for depreciation.
Don't try to get tricky. One taxpayer who had a kennel operation lost in Tax Court in large part because the IRS went to the town and found out he claimed the kennel was a hobby, not a commercial venture, so he wouldn't have to get a license and pay higher real estate taxes. He saved on the kennel license and associated taxes, but lost the big dollar battle to deduct his losses. You can't have it both ways.
Don't be foolish. You're unlikely to convince the IRS or a court that the thousands of dollars spent on your teenage daughter's golf lessons, equipment, greens fees, etc. had a profit objective.
You won't automatically be able to overcome the hobby loss issue by claiming the activity was actually advertising for your main business. For example, putting the name of your law firm on the side of your boat and claiming a deduction for the boat expenses. On the other hand you may be able to convince the court it's advertising if you deal strictly in maritime law and boating while intoxicated cases. Some taxpayers engaged in auto racing have won their cases because their primary business was auto repair or an auto dealership. You'll have a better chance of suceeding if construct a good basis right from the start. Talk to your tax adviser.
Even if you're never challenged on the profit motive of your venture, you still have to pass the passive activity and basis tests. That is, in order to claim the losses you have to materially participate in the activity and have sufficient basis to take the losses. There are a number of different tests for material participation.
What are your chances if challenged by the IRS? Based on the court cases (there have been hundreds of them over the years), the IRS is victorious in the vast majority. But a closer examination shows most taxpayers lose because they're not taking even the most basic steps to improve their position. There's nothing you can do to make auto racing not have an element of pleasure, but you can:
Deducting Hobby Expenses
What if you're sure your activity doesn't qualify as a business? You still have to report any gross income, but in the past you could be able to deduct related expenses up to the amount of the income. That is, you couldn't create a net loss, but you could at least offset the income.
Under prior law the expenses would be broken down into three categories. The first are deductions you can take for personal as well as for business activities. For example, you use 20% of your home for the activity. You can deduct your real estate taxes regardless of the use of the property for business. Your real estate taxes are $4,000. You can deduct $3,200 on the tax line of Schedule A and $800 against the business income. (Mortgage interest would also be included here.)
The second category are deductions that do not result in an adjustment to the basis of property. You incurred $3,200 for advertising and $600 for electric to run a machine. The $3,800 is potentially deductible. Other expenses include small tools and supplies, insurance, interest, etc.
The final category are expenses that decrease the basis of property. That's depreciation, amortization, and the part of a casualty loss that you could not deduct as an individual.
For example, you generate $2,600 from repairing small engines. The business' share of real estate taxes is $800 (the only expense in the first category). That reduces the income to $1,800. You can deduct $1,800 of expenses in the second and third categories. You can't deduct more than $1,800 for supplies, advertising, etc. expenses.
But there's bad news on all fronts here. First, as shown above your deductions may be limited. Second, you'll have to apply normally personal expenses first. If you use part of your home for business, you must allocate a portion of the real estate taxes (and mortgage interest). Third, the deductions would only be allowed on Schedule A, miscellaneous deductions. That's where the real problem arises. There is no longer any deduction for itemized expenses subject to the 2% floor under the Tax Cuts and Jobs Act. Fourth, the income is reported on Line 21 of Schedule A unreduced by the expenses, and increases your AGI. That can affect a number of thresholds and limitations. For example, Fred's only other income is from social security, $25,000. He's single and would pay no taxes on the income. But he has $60,000 of gross income (and a larger amount of deductions) from his engine repair business. Fred would have to include 85% of his social security income in his AGI because the gross income from the business
The bottom line is if your activity generates $20,000 in income and $30,000 in deductions and the IRS suceeds in labeling it a hobby, you'll have an additional $20,000 in income with virtually no chance of an offsetting deduction. That's the worst of all worlds. What's worse is that the IRS now has additional incentive to make sure they win the fight to tag the activity a hobby. But many of the provisions of the Tax Cuts and Jobs Act are set to expire in 2026. Talk to your tax advisor. He may have some suggestions in your particular situation.
Copyright 2005-23 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
--Last Update 07/19/23