Small Business Taxes & Management^TM--Copyright 2016, A/N Group, Inc.

TIGTA Issues Audit Report on Hobby Losses

Over the years we've had a number of questions about hobby losses. The issue arises when a taxpayer has an activity that generates losses that offset his or her other income. Classic cases involve high-income taxpayers who engage in horse breeding to be able to deduct expenses of providing horses for their children to ride. Or the taxpayer who claims yacht chartering or auto racing is a business when it's clearly a hobby. Unfortunately, many start-up businesses can also come under IRS scrutiny because they can generate losses for more than a few years.

We discussed the basics in our article Hobby Losses. One point to keep in mind is that you can have a number of years of substantial losses if you can show you intended to make a profit on the venture and conversely having small profits during a few years may not convince the IRS the venture isn't a hobby. You should also keep in mind that taxpayers lose most cases when they challenge the IRS's hobby loss claim in Tax Court. But that's often the taxpayers fault because they go in with a weak case.

But what are you chances of getting picked for an audit? You could be selected if you based on your DIF (Discriminant Index Function) score (between 40 and 60 percent of returns are selected for audit this way). How the IRS arrives at DIF score is a secret. Or your losses on a Schedule C or from an S corporation could be examined after your return is picked for audit because of high charitable contributions relative to income or some other reason and the auditor questions the losses. The Treasury Inspector General for Tax Administration (TIGTA) recently published a report demonstrating that the IRS could easily identify a significant percentage of returns with hobby losses by analyzing data it has in its database. The TIGTA report used information from the IRS database to identify potential hobby loss activities. TIGTA report noted that in tax year (TY) 2013 687,382 taxpayers reported over $7.1 billion in losses from Schedule C businesses that also reported losses in the previous three tax years (TYs 2010 through 2012).

The TIGTA report noted that 157,913 taxpayers reported average Schedule losses of $7,993 with no gross receipts. Those taxpayers had average total positive income of $198,960. Another 312,828 taxpayers had average losses of $6,825, gross receipts from $1 to $4,999 and income of $107,136. In total, sixty-eight percent of these taxpayers (470,741 of 687,382) reported less than $5,000 in gross receipts in TY 2013. In the final strata 84,462 taxpayers reported gross receipts of $20,000 or more, average losses of $108,454 and income of $251,883.

To determine the compliance rate with the tax law regarding hobby losses, TIGTA 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. TIGTA used these criteria because the materiality of the taxable income offset would likely make these returns a high priority for IRS Examination resources.

For the 9,699 returns, the average reported wage income was $238,634, with 4,321 returns (45%) having total positive income of $200,000 or more and 372 having total positive income of $1 million or more. More than 64 percent (6,231, of 9,699) of these returns also had gross receipts of less than $5,000, and almost 35 percent (4,473 of 9,699) had no gross receipts. The average reported Schedule C loss was more than $40,000, with a median loss of $28,889. Therefore, an individual in the sample population with an average wage income of $238,634 who reported a median Schedule C loss of $28,889 could inappropriately avoid as much as $8,000 in income taxes of the Schedule C was due to a hobby loss. As of May 2015, 409 of the 9,699 returns (4.2 percent) had been selected for audit. TIGTA researched the project code descriptions for the 409 returns, and none appear to have been selected exclusively for potential hobby losses, although the examiner could decide to include the issue in the audit.

From the population of 9,699 returns identified by TIGTA's analysis, it randomly selected a statistically valid sample of 100 returns for review. Based on a review of the tax returns, TIGTA determined that 88 returns (88%) showed an indication that the Schedule C businesses were not being engaged in for profit. TIGTA estimated that 7,511 returns from the total sample population of 9,699 taxpayers may have inappropriately used hobby losses to reduce income taxes by as much as $70.9 million for TY 2013.

This seems a perfect area for the IRS to use computer analysis to select returns for audit. Whether that will happen or how soon is anyone's guess.

Information From IRS Audit Guide on Hobby Losses

The IRS has an audit guide (Activities Not Engaged in For Profit (ATG)) that provides some insight into what an IRS auditor will be looking for when pursuing a hobby loss case with respect to a Schedule C. Included is a list of activities high on the hobby loss list:

Airplane Charter
Artists
Auto Racing
Bowling
Craft Sales
Direct Sales
Dog Breeding
Entertainers
Farming
Fishing
Gambling
Horse Breeding
Horse Racing
Motorcross Racing
Photography
Rentals
Stamp Collecting
Writing
Yacht Charter

IRS auditors may also look at issues other than whether Sec. 183, the hobby loss section applies. These Sections include:

Sec. 162 Ordinary and Necessary Business Expenses
Sec. 167 and 168 Depreciation
Sec. 179 Election to Expense Certain Depreciable Assets
Sec. 195 Start-Up Expenses
Sec. 212 Expenses for Production of Income
Sec. 280A Disallowance of Certain Expenses in Connection with Business Use of Home, Rental of Vacation Homes, Motor Homes, Yachts, etc.
Sec. 274 Record Keeping Requirements
Sec. 465 At-Risk Limitations
Sec. 469 Passive Activity Loss Limitations
Sec. 704 Partnership Loss Limitations
Sec. 1366 S Corporation Stock or Debt Basis Limitations

Other issues cited in the Audit Guide include:

• Deducting all or most of the cost of maintaining a personal residence. Taxpayers sometimes erroneously claim that the “exclusive use” restriction of Sec. 280A can be avoided by placing business-related items in any given room of the house. The taxpayers sometimes cite the Sec. 280A(c)(2) exception for storage use (storage on a regular basis of inventory or product samples). For example, the taxpayer may erroneously claim that if a poster, calendar, desk, file cabinet, telephone or other business item is placed in a room that secures the room’s business status without regard to the fact that the room is used for personal purposes as a kitchen, bathroom, child’s bedroom, etc.
  
• Paying children and/or family members for household duties that are not ordinary and necessary to the operation of any business (e.g. disposing of trash, mowing the lawn, answering the telephone, washing cars). Also, the payment may be excessive for the services performed.
  
• Deducting family education expenses by claiming an Education Assistance Program for family members claimed as employees. Sec. 127.
  
• Deducting excessive car and truck expenses when the vehicle was used for both personal and business use. Taxpayers sometimes claim a business purpose for every trip, whether it is to commute to a regular job or a trip to the grocery store, golf course, church, etc. Taxpayers sometimes erroneously argue that the trips are deductible given that there is always a potential of recruiting new clients.
  
• Deducting personal furniture, home entertainment equipment, children’s toys, etc.
  
• Deducting personal travel, meals, and entertainment under the guise that since everyone is a potential client, these are deductible, not personal expenses.
  
• Deducting 100% of personal medical expenses merely by “employing” a family member who is not a bona fide employee and creating a medical reimbursement plan.

You should not be discouraged from taking losses from a business, but you should be aware of the dangers. You can mitigate your chances of losing a deduction by keeping good records, getting professional advice on managing the business, etc. Just "winging it" and hoping for a profit can get you into trouble.

--Last Update 05/12/16