If you don’t run it like a business the IRS might call it a “hobby!”
Many successful taxpayers engage in “other business activities” that frequently produce income tax losses. While the tax law contains many restrictions on tax loss utilization frequently taxpayers overlook the “hobby loss” rules. These rules make otherwise tax compliant business activities’ losses unavailable to their owners.
We know that if an activity records a profit in two (2) of five (5) successive tax years (or three (3) or seven (7) for horse activities) a rebuttable presumption of “non-hobby” status arises. However that presumption is rebuttable as opposed to irrefutable.
Recently two cases were decided; one taxpayer favorable and one IRS favorable applying the “hobby loss” rules which are instructive on how to preserve their tax losses.
These cases represent polar opposites in “hobby loss” compliance as discussed in the tax regulations. The regulation’s non-exhaustive factors list is aimed at determining if the taxpayer has an actual and honest profit objective as opposed to merely attempting to treat a “hobby” as a business. Those factors are—
Non-exhaustive factor list:
- Manner in which taxpayer carries on activity;
- Taxpayer’s expertise and taxpayer’s advisors;
- Time and effort expended in carrying on the activity;
- Expectation that assets will appreciate in value;
- Taxpayer’s success in other activities;
- Activity’s income and loss history;
- Amount of occasional profits;
- Taxpayer’s financial status; and
- Elements of personal pleasure.
In the Zenzen case the taxpayer, a professional auto mechanic, operated an auto racing activity which involved only the taxpayer and his children. During racing season he worked in auto preparation for thirty (30) hours per week. He received nominal income year to year. No books and records were maintained. Although he worked thirty (30) hours per week, most of that time was spent with his children. His losses were over 54 times the income earned. The taxpayer engaged in auto racing as a hobby prior to treating the activity as a business.
In the Blackwell case, the taxpayer and his wife (an executive and nurse) were horse breeders. The husband created a detailed, professional business plan and wife attended, and secured a bachelor’s degree for horse healthcare. They purchased and sold a number of horses, few for a profit. They acquired and used commercial horse breeding accounting software. When profits weren‘t forthcoming taxpayers secured consulting services from professionals in the field. And, when no profit was derived the taxpayers shut the business down.
As you might expect Zenzen is where the taxpayer lost and Blackwell is where the taxpayer won. What we should take away from these cases is, “If you don’t run, manage, capitalize, pursue profits and avoid losses like you do in your principal business the “hobby loss” rules will not look favorably on your activity.” If you are engaged in any secondary business a “hobby loss analysis” is good preventive medicine against forfeiting current and prior tax losses. Your H &M tax representative can assist you with a “hobby loss analysis”.
TAGS: Individual; business; tax losses; hobby losses;