August 10, 2023

Your Favorite Hobby Doesn’t Get Favorable Tax Treatment

By Kelly Yim, Director, Tax & Business Services

Your Favorite Hobby Doesn’t Get Favorable Tax Treatment Tax & Business

You think you should be able to deduct the expenses associated with your hobby. The Tax Code says you can up to a specific limit. But there is a hobby loss trap “below the line” on your Form 1040. See itemized deductions on Schedule A. Can’t find it? You already did! The two-percent miscellaneous itemized deductions category to report the hobby expenses were removed for the years 2018-2025 by the Tax Cuts and Jobs Act (“TCJA”). The tax consequence is significant. Because there is no line to report the hobby expenses on Schedule A, treating these hobby expenses as miscellaneous itemized deductions would cause these amounts to be nondeductible. (For tax years after 2025, miscellaneous itemized deductions are deductible, subject to the two percent of AGI limitation.)

The next logical question is, “Can the hobby expenses be reported elsewhere, perhaps “above the line” on Schedule C, Profit or Loss from Business?” You can’t do that either. The 11th Circuit Court of Appeals (“11th Circuit”) issued its decision in Gregory v Commissioner, Case No, 22-10707, affirming a Tax Court decision holding that the deductions related to a hobby should be reported “below the line” on Schedule A as miscellaneous itemized deductions, not “above the line.”

Carl and Leila Gregory chartered their yacht, Lady Leila, in 2014 and 2015. They did not conduct the chartering activity for profit—it was a hobby. Though the hobby generated income, it also incurred sizeable expenses each year. The Gregorys deducted those expenses on Schedule C of their income tax return to reduce their gross income from the activity. Upon selection for examination and subsequent audit, the IRS recharacterized the gross receipts on Schedule C as non-Schedule C “other income,” after concluding they lacked a profit motive with respect to their charter activity. In addition, the IRS recharacterized the reported Schedule C expenses as miscellaneous itemized deductions to the extent of income generated from the charter activity, except for expenses reported for “taxes and licenses.” However, because the Gregorys’ total miscellaneous itemized deductions for both years at issue were less than two percent of their adjusted gross income (“AGI”), the IRS disallowed the charter expenses (except for tax expenses) altogether. (Note: the years in question here are before TCJA, so miscellaneous itemized deductions are deductible to the extent they exceed two percent of the taxpayers’ AGI.)

The IRS issued a notice of deficiency for taxable years 2014-2015 to the Greogrys. Facing deficiencies and substantial penalties, the Gregorys petitioned the Tax Court to reconsider the deficiencies, arguing that hobby expenses are not miscellaneous itemized deductions subject to the two-percent limitation. The Tax Court disagreed, determining that the Code’s plain language and statutory scheme confirmed the itemized deduction treatment. The Gregorys filed a motion for reconsideration, which the Tax Court denied. The Tax Court issued a final decision upholding the tax deficiencies. The Gregorys then timely appealed.

The case was brought forward to the 11th Circuit, which must decide where those deductions belong on a taxpayer’s return: above the line (reducing gross income) or below the line as miscellaneous itemized deductions (reducing adjusted gross income). The distinction is vital because “above the line” expenses are usually deductible in full, whereas “below the line” expenses must rise above a statutory floor to trigger a deduction or may not be available to taxpayers whose income exceeds a certain threshold.

To answer the “above or below the line” question, the 11th Circuit turned to the Code because the amount and type of deductions available to taxpayers depend upon legislative grace. A taxpayer seeking a deduction must be able to point to an applicable statute and show that they come within its term. The Code offers two types of deductions: “above the line” and “below the line.” The 11th Circuit first walked through the list of “above the line” deductions. Although the list is exhausting, it nowhere mentions hobby expenses. Next, the 11th Circuit moved to the list of “below the line” deductions, which includes all deductions except:

  1. The “above the line” deductions.
  2. The standard deduction.
  3. The personal exemption deduction.
  4. The qualified business income deduction.
  5. The charitable contribution deduction.

Since hobby expenses are not one of the listed exceptions, the 11th Circuit concluded that the deduction for hobby expenses must be an “itemized deduction.” Lastly, the 11th Circuit came to the miscellaneous itemized deductions provisions. The Code defines “miscellaneous itemized deductions” as all “itemized deductions” other than twelve specific listed deductions, none mentioning hobby expenses. Thus, hobby expenses are miscellaneous itemized deductions and deductible only to the extent that the aggregate of such deductions exceeds two percent of AGI.

In summary, the 11th Circuit concluded that the provisions of the Code, taken together, answer the “above or under the line” question and held that hobby expenses are “below the line” miscellaneous itemized deductions. In addition, the 11th Circuit noted that while other circuit courts have not yet decided on this issue, there is support for this result in several lower court opinions (e.g., Purdey v United States, 39 Fed Cl, 413 (1997), Strode v Comm’r, 109 TCN 1599 (2015)) and in regulation sec 1.167-1T(a)(1). Finally, tax analysts and commentators also support this conclusion. As a result, the 11th Circuit agreed with the Tax Court and denied the petition for review.

The IRS regulations state that the hobby loss rules won’t apply if the facts and circumstances show you have a profit-making objective. So, to avoid the hobby loss rule, you must show that you intend to turn the activity into a profit-making business rather than operate it as a mere hobby. Whether an activity is a business or a hobby has always been problematic for people who make money from activities usually done for pleasure. Luckily, Marcum has lots of experience dealing with this subject matter. To avoid the hobby loss trap, consult your Marcum advisor today.