The Internal Revenue Code (the “Code”) Section 162 allows businesses to deduct their ordinary and necessary expenses against the income generated by their trade or business. If the expenses exceed the income in a given year, a net operating loss may arise. For taxpayers that report their businesses on a Schedule C on their Form 1040, or that operate as an S Corporation or Partnership, the net loss from one business may offset the income from another activity that appears on their Form 1040 tax return. This is permitted by the Internal Revenue Code unless the IRS determines that your business is actually just a hobby. If the activity is a hobby under Code Section 183, expenses related to the activity are not deductible as a business expense under Code Section 162.
It used to be that if a business was deemed a hobby, the business owner could at least deduct the expenses from the activity to the extent of the income from the activity. This was done as a miscellaneous itemized deduction on the taxpayer’s Schedule A. However, the Tax Cuts and Jobs Act passed in December 2017 eliminated the miscellaneous itemized deduction in the 2018-2025 tax years. As a result, the expenses of a “hobby” will no longer offset the income from that activity. This has raised the stakes for struggling business owners who have yet to show a profit because hobby determinations will have a more severe financial impact than in prior years.
As an example, assume that Dr. Bob is a successful physician and has a side business breeding and selling show horses. The horse business has yet to be successful and has suffered losses for the last 7 years. Those losses were reported on Dr. Bob’s tax return and offset his taxable income from his medical practice such that he had a substantial reduction in the taxes he owed. Dr. Bob is audited and the IRS determines that his horse business is merely a hobby and disallows all of the expense deductions from the activity. This means that the medical practice income will no longer be reduced by the losses and the previously offset income and the gross receipts from the “hobby” will now be subject to tax…and penalties…and interest.
Under Internal Revenue Code Section 183, business expense deductions will not be allowed if the activity “is not engaged in for profit.” An “activity not engaged in for profit” means “any activity, other than one with respect to which expense deductions are normally allowed.” This unhelpful definition does little to tell a business owner what they need to do to avoid being classified as a hobby. One must turn to the related Treasury Regulations to understand how this rule is applied.
Whether or not an activity is a business or hobby is ordinarily determined by analyzing 9 factors found in the Treasury Regulations. Knowing what these factors are in advance can help a business owner plan and take certain steps to overcome any hobby loss question that arises.
The factors are:
1. The manner in which the taxpayer carried on the activity.
2. The expertise of the taxpayer or his or her advisers.
3. The time and effort expended by the taxpayer in carrying on the activity.
4. The expectation that the 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 loss with respect to the activity.
7. The amount of occasional profits, if any, which are earned.
8. The financial status of the taxpayer.
9. Elements of personal pleasure or recreation.
Each of these factors are intended to provide insight into the profit motivation of a taxpayer. It is important to mention that no single factor controls and that other factors may be considered. The mere fact that the number of factors indicating the lack of a profit objective exceeds the number indicating the presence of a profit objective is not conclusive. That is, it is not a question of just adding up how many factors fall on the hobby or business side.
We’ll discuss each of these factors further in later posts to help provide some insight into how a business can document its profit motive in the event of a hobby loss audit. We’ll also discuss the existing safe-harbor that can be satisfied to avoid a hobby determination.
Rob Teuber is a tax attorney with the law firm von Briesen & Roper s.c. He works with individual and business clients across the U.S. to resolve their Federal tax issues. He also works with Wisconsin taxpayers to resolve issues with the Wisconsin Department of Revenue from his offices in Milwaukee and Waukesha, Wisconsin.