September 30, 2015
IRS Audit | Business Loss vs. Hobby Loss Rules
9 Factors That May Cook Your Goose In An Audit- Business Loss vs. Hobby Loss Rules
IRS uses the business vs. Hobby loss rules as the go to argument whenever a business has losses for an extended period of time; they try to rule the activity as a hobby. Why is that important? A “hobby” can only take expense deductions up to, but not exceeding, the level of income. A hobby cannot produce a loss that can be used to offset other income on the return. A “hobby” cannot produce a Net Operating Loss that may be carried back two years or forward 20 years. Therefore in an audit, the IRS always asks questions that may lead to a hobby loss ruling.
The IRS uses 9 factors to determine if an activity is considered a hobby;
(1) The manner in which the taxpayer conducts the activity; (2) the expertise of the taxpayer or his/her advisers; (3) the time and effort spent by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer’s history of income or losses with respect to the activity; (7) the amount of occasional profits, if any; (8) the financial status of the taxpayer; and (9) elements of personal pleasure or recreation. Sec.1.183-2(b), Income Tax Regs.
No factor or group of factor s is controlling, nor is it necessary that a majority of factors point to one outcome. See Keating v. Commissioner, 544 F.3d 900, 904 (8th Cir. 2008), aff’g T.C. Memo. 2007-309; Engdahl v. Commissioner, 72 T.C. 659, 666 (1979) (taxpayer’s profit motive must be ascertained “not on the basis of any one factor but on the basis of all the facts and circumstances”); sec.1.183-2(b), Income Tax Regs. Certain factors may be accorded more weight in a particular case because they have greater salience or persuasive value as applied to its facts. See Vitale v. Commissioner, T.C. Memo. 1999-131, 77 T.C.M. (CCH) [*29] 1869, 1874, aff’d without published opinion, 217 F.3d 843 (4th Cir. 2000); Green v. Commissioner, T.C. Memo. 1989-436, 57 T.C.M. (CCH) 1333, 1343(noting that all nine factors do not necessarily apply in every case)
Manner In Which The Activity Is Conducted
Conducting your business in a businesslike manner MAY show that you INTEND TO MAKE A PROFIT. The facts that evidence a businesslike manner include;
- The maintenance of a complete and accurate books and records;
- The taxpayer conducts his/her business in a manner resembling the way successful business owner would conduct their business;
- Taxpayer changes his/her operating procedures, adopts new techniques, or abandons unprofitable techniques and activities in a manner consistent with a desire to improve profitability, and;
- Consistent marketing and advertising and refining these activities based upon success and failure.
Note: The best way to document profit motive is to prepare, maintain and consistently revise a business plan. The key point is to consistently document the changes you are making in your pursuit of a profit.
Expertise Of The Taxpayer and His/Her Advisors
The taxpayer’s expertise, research and the study of the accepted practices in the taxpayer’s industry, as well as consulting with experts is an indication of a profit motive.
Taxpayer’s Time and Effort In The Activity
The fact that the taxpayer devotes “considerable” time and effort to the activity may indicate a profit motive. This effort need not be exclusive. A taxpayer may have more than one trade or business simultaneously. The similarity or dissimilarity to the other activity may be a factor in determining the total effort as it relates to this activity.
Note: The best way to document your efforts is by keeping a body log or a diary of all of your efforts.
Expectation Of An Appreciation In Value
An expectation that the assets used in the business will appreciate in value may indicate a profit motive. This would be true even if the taxpayer derived no income from the operation of the company, as long as the taxpayer may reasonably “entertain” an expectation of asset appreciation, it would indicate a profit motive.
Taxpayer’s Success in Other Activities
A track record of success in other business ventures may indicate that the taxpayer has the skills and determination to succeed in subsequent ventures. The lack of prior business experience in and of itself will not be a deciding factor.
History of Income Or Losses
The fact that a taxpayer incurs a series of losses beyond an activities “startup years” may imply the absence of a profit motive. This inference may not arise where losses due to “customary business risks or reverses” or to “unforeseen or fortuitous circumstances which are beyond the control of the taxpayer.” Some activities are subject to a longer period of losses before becoming profitable.
Amount of Occasional Profits
The fact that a taxpayer derives some profits from an otherwise money-losing venture may support the existence of a profit motive. The opportunity to earn a substantial ultimate profit in a highly speculative venture is ordinarily sufficient to indicate a profit motive.
Taxpayer’s Financial Status
The fact that the taxpayer lacks substantial income or capital from sources other than this activity may indicate a profit motive.
Element Of Personal Pleasure
The fact that a taxpayer derives personal pleasure from the activity, or finds it recreational, may suggest that he or she engages in it for reasons other than making a profit. The derivation of personal pleasure, however, “is not sufficient to cause the activity to be classified as not engaged for profit. The market efforts of the business are a real key to profit determination. If an activity has an element of pleasure, it is important to document the activities performed by the owner(s) that are not typically considered pleasurable.
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