Entrepreneurs: Beware of the Hobby Loss Rule
On May 4, 2016, the Treasury Inspector General for Tax Administration in its published audit report found that the Internal Revenue Service can improve its methods for identifying high-income taxpayers who may be offsetting their income with “hobby losses” from unprofitable business activity. It was reported as well that IRS management would take corrective actions. Hence, it is imperative that closer attention is paid to business operations which have incurred losses over the years. We may point out as well that the issue as to whether a taxpayer is engaged in an active trade or business versus a hobby is one of the most frequently litigated and controversial areas of individual income tax law.
The provisions within the Internal Revenue Code apply to individuals operating as sole proprietors, S-Corporations, partnerships and trusts and estates. Although we may hear about this issue more often in the context of horse breeding and gambling, it must be noted that the issue should be taken into consideration in any business endeavor such as farming, entertainment, art, aviation and rentals, to name a few.
Could an activity be deemed a hobby?
In determining whether the activity could be deemed a hobby, we look at the nine factors cited within the IRS regulations:
- Manner in which the taxpayer carries on the activity. It is expected that the taxpayer takes all necessary steps to ensure that the business is profitable or seeking to be profitable and is conducting all activity in a business-like manner. Some key indicators (not all- inclusive) which could demonstrate that an activity is conducted in a businesslike manner would be: maintaining separate books and records; having a documented business plan that is monitored and revised periodically as your business landscape is changing; having a documented product or service line that demonstrates innovation with a profitability imperative.
- The expertise of the taxpayer or the taxpayer’s advisors. It is expected that the owner and/ or managers are specialists in their industry based upon past experience and educational background.
- The time and effort expended by the taxpayer in carrying on the activity. The time devoted by a taxpayer or his/her employees must demonstrate that the taxpayer is actively engaged in the business. The key is to be active in the operations and not simply the administration or financing of the business.
- Expectation that assets used in the activity may appreciate in value. It must be pointed out that the reliance on appreciation could be construed to mean that the operation is not engaged for profit. Such expectation should be a beneficial side effect of the business operations.
- The Success of the taxpayer in carrying on other similar or dissimilar activities. It may be particularly advantageous if a taxpayer has turned around other businesses. Is there a history of turning unprofitable businesses into profitable ones?
- The taxpayer’s history of income or losses with respect to the activity. Recurring losses over the years can pose a high hurdle to overcome if the activity’s profitoriented status is questioned.
- The amount of occasional profit, if any, which is earned. The statutory safe harbor could be relied upon, if met, to generate a profit in at least three out of five years of operation, or in the case of horse racing, breeding, training or showing, two out of seven.
- The financial status of the taxpayer. Substantial income from other sources could present a high hurdle for a taxpayer to overcome in order to establish that a business with a loss is engaged in for-profit activity. Although this view may not be the Internal Revenue Service’s policy statement, a representative noted during an examination that the Service is “not in the business of subsidizing wealthy people’s folly.” Hence, when a taxpayer with means continues to fund a business operation that does not generate a profit year after year, the taxpayer may find it a high hurdle to overcome if the issue of a hobby loss is raised by the Internal Revenue Service.
- Elements of personal pleasure or recreation. Although most businesses thrive because of the passion their owners have for the enterprise, extreme caution must be exercised so that the business is clearly identified as work with a profit motive.
When could a taxpayer have an exposure to the hobby loss rule?
The Internal Revenue Service could raise the “hobby loss” rule within a number of situations; for example, during the years the business is operating or upon termination of a business activity. In various instances, the IRS could conduct an audit upon the termination of a business. Hence, if a business incurred losses over three of five years of operations, there is an exposure to the “hobby loss” rule.
Potential “hobby loss” exposure for a business could also occur when passive losses are freed up upon the disposition or sale of the business. Such situations are particularly prevalent when dealing with farming activities, which tend to operate at a loss. Taxpayers occasionally may believe that it would be conservative not to claim losses during the years that a farming activity is running a loss. However, this is a significant pitfall because the taxpayer would have essentially declared to the IRS that the business was not active, and this could be classified by the IRS as a “farm shelter.”
Similar exposure can also be realized in rental activities where the taxpayer is renting a home to related parties.
One pitfall that may seem like a remedy is the filing of IRS Form 5213 (Election to Postpone Determination as to Whether the Presumption Applies That an Activity Is Engaged In for Profit). A taxpayer may think he or she is buying time to generate profit and thus prolong the statutory safe harbor period. However, this can backfire since the taxpayer would in effect be suggesting to the Internal Revenue Service that he/she is uncertain about the business’s potential to make a profit.
As the Internal Revenue Service is revving up its examination of businesses generating losses, entrepreneurs must approach all business operations with the nine factors above as part of their business models, to ensure surviving an examination or audit related to the hobby loss rules.