Clients will always tell you it’s a for-profit business; however, the IRS
doesn’t take a taxpayer’s statement of intent as the sole factor. There must be
other factors to rely on besides a taxpayer’s verbal statement. Often, a
taxpayer earning more than $100,000 at their job will develop a “hobby” and
claim that they operate a business so they may attempt to deduct their losses
and reduce other taxable income.
The business vs. hobby issue has been problematic for the IRS. Now, more than
ever, the service is beginning to scrutinize tax returns with losses,
especially those with multi-year losses.
On Sept. 27, 2007, the U.S. Treasury Inspector General for Tax Administration
issued a report stating that significant challenges exist in determining
whether taxpayers with Schedule C losses are engaged in tax abuse. The review
looked at high-income, self-employed taxpayers who had income of $100,000 or
more, and filed a Schedule C with losses on their tax return. The report stated
that many of the Schedule C businesses were not-for-profit, resulting in $2.8
billion in taxes avoided in 2005. Of the tax returns prepared in this area, 73
percent were prepared by tax professionals.
Does this mean that tax professionals are taking their clients’ statements
at face value and not conducting sufficient due diligence to consider other
factors that may provide a better determination of their clients’ ventures?
A taxpayer operating a for-profit business under IRC §162 should be able to
prove that a bona fide business exists. It is presumed that a taxpayer is
operating a for-profit business if there is a profit in three years out of
five-year period. If the taxpayer is operating a horse business, there should
be a profit in two years out of seven years.
No bright lines
However, there is no single factor that determines if a venture is a bona
fide business or a hobby. Some businesses take more time than others to become
profitable, and in the current economic climate, many businesses still struggle
to turn a profit. As a result, not turning a profit is not the sole determining
factor.
The IRS and tax courts use the nine factors below to determine if a taxpayer
is operating a for- profit business or if the business is a hobby being used to
deduct expenses for tax avoidance purposes.
1. The manner that a taxpayer carries on an activity.
2. The expertise of a taxpayer or advisor(s) involved in the business
activity.
3. The time and effort a taxpayer allocates to the activity.
4. Has the taxpayer had success with similar or dissimilar activities in the
past?
5. The history of income/loss for the activity.
6. Are there occasional profits and, if so, how much are they?
7. The financial status of the taxpayer, and does the taxpayer rely on this
business activity or does the taxpayer have other sources of income?
8. Is there an expectation of asset appreciation for any assets involved in
the business activity?
9. Are there elements of personal pleasure or recreation?
Not one factor of the nine will be a determining factor. Consideration
should be given to all factors in making a proper determination. Each taxpayer
is unique and shouldn’t be compared to another taxpayer. For example, not every
taxpayer will allocate the same amount of time, and not every taxpayer will have
the same background, education or financial resources to allocate to their
venture.
If a taxpayer’s activity has ongoing losses and doesn’t turn a profit in
three years out of five years, the IRS may conduct an audit and make a
determination that the activity is a hobby. The accountant should look to see
if the losses are due to circumstances out of the control of the taxpayer, if
they are due to start-up expenses, or whether the losses are because the
activity is a hobby. If a loss occurs in multiple years, you should look to see
if the taxpayer has made any changes to the operations to improve
profitability, or if the taxpayer continues to operate the same way year after
year.
In addition, other considerations should be given to the type of activity and
whether it is one that happens to take more time than normal to turn a profit,
particularly in a recession economy. Furthermore, in evaluating the activity,
questions should be asked of the taxpayer, such as whether the taxpayer
acquired a loan to start up the business or for operating capital. Would anyone
operating an activity as a hobby get into debt and personally guarantee a loan
just to create a loss? There are so many factors to consider and use for a
favorable argument of the taxpayer’s activity.
Gray areas
As mentioned earlier, the report released by TIGTA states that a large
number of taxpayers file a Schedule C with losses on their tax return to offset
other income. If the determination is made that an activity is not for profit,
the losses will not be deductible, thus offsetting other income will not be
allowed. The hobby loss rules limit deductions to the extent of income from the
activity. Hobby loss limits under IRC §183 apply to individuals, estates, S
corporations, partnerships and trusts. The loss limits do not apply to C
corporations.
If a taxpayer is placed under audit for this matter and a determination is
made by the IRS that the activity is a hobby, the taxpayer can make an election
under IRC §183(e) to postpone the determination by filing Form 5213. The
election will postpone the determination of the hobby presumption until the
close of the fourth taxable year or the sixth taxable year for horse
activities. If the election is made, the taxpayer may continue to file tax
returns in the interim on the assumption that the activity is for profit. An
election made by a partnership or an S corporation is binding upon all partners
or shareholders associated with the entity.
As taxes continue to increase in the coming years, taxpayers will try to
reduce their taxable income by filing a Schedule C with losses. As a tax
professional, you should conduct due diligence for taxpayers who file a
Schedule C on their tax return, making sure they are operating a for-profit
business and not a hobby. Always be cautious and aware of the ramifications of
making an incorrect determination.
IRS Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we
inform you that, to the extent any advice relating to a Federal tax issue is
contained in this communication, including in any attachments, it was not
written or intended to be used, and cannot be used, for the purpose of (a)
avoiding any tax related penalties that may be imposed on you or any other
person under the Internal Revenue Code, or (b) promoting, marketing or
recommending to another person any transaction or matter addressed in this
communication
