Business or Hobby: Which is It?
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are also 3 online review questions to answer per hour.
Business or Hobby
That is the Question
IRC §162 & 183
Presented by Andrew G. Poulos, EA, ABA, ATP
2
Learning Objectives
Upon completion of this webinar you will be able to:
• Assess and determine if your clients are operating a real business
vs. a hobby.
• List nine factors to consider for differentiating between business
vs. hobby losses.
• Implement the use of a list of key questions and items to help
analyze and distinguish between a business or a hobby.
• Recognize the guidelines needed to understand the differences in
IRC Sec. 162 vs. IRC Sec. 183.
• Determine which category a venture falls in, and what the tax
effects are if for operating a hobby vs. a business.
• Recognize the hobby loss limitation rules and calculate how to
deduct expenses for a hobby versus a business.
3
TIGTA Report
• 9/27/07 – “Significant Challenges Exist in Determining
Whether Taxpayers with Schedule C Losses are Engaged in Tax
Abuse”
• Review looked at high income SB/SE taxpayers
• Total income of $100,000 or more
4
TIGTA Report Continues
• Losses reported on Schedule C of Form 1040
• Activities considered to be NOT for profit
5
TIGTA Audit Results
• Hobby expenses limited to hobby income
• 1.5M with significant other income filed Schedule C, only
losses for 2002-2005
• 73% prepared by tax professionals
• 2.8B in taxes avoided in 2005
6
Notes in TIGTA Report
• Only Schedule C losses included
• 4 years of consecutive losses
• Total income sources of $100,000 or greater
• No Schedule F, only Form 1040
7
Changes Are Needed
“To prevent taxpayers from continually deducting losses in
potentially not-for-profit activities to reduce their tax
liabilities.”
8
Is Hobby a For-Profit Endeavor?
• FS-2008-23 – June 2008
• IRS reminds taxpayers with guidelines
• IRC Section 183 – Hobby Loss Rule
• In general: deductions allowed for ordinary and necessary
business expenses
9
IRC Sec. 162 Considerations
• Ordinary and necessary expenses – trade or business
• Ordinary – common and accepted in the trade or business of
taxpayer
• Necessary – appropriate for the trade or business of taxpayer
10
Is Activity Important?
• Qualifies as business – If carried on with actual and honest
expectation of earning a profit
• Activity not for profit – Losses may not be used to offset other
income
• Income – Related Expense = Loss
11
Is it a Business Expense?
• Must meet requirements of:
a) Carrying on Trade or Business
b) For Production of Income
• Failing to meet either, consider IRC Sec. 183
12
For Consideration
• Relevant Factors
• Include all pertinent facts
• IRC 183 – Activities Not Engaged in For Profit – Hobby Loss
13
We Must Understand
• Understand deductible business expenses
vs.
• Non-deductible hobby expenses
14
Distinguishing Between
• Business Activity – IRC § 162 Expenses
• Non-business “for profit” – IRC § 212 Expenses
• Not engaged in for profit – IRC § 183 limitations on deductions
• Personal activity – Deductions disallowed by IRC § 262 except to
extent not otherwise allowable
15
Applicable Code Sections
• Sec. 162 - Trade or Business Expenses
Deduction for all ordinary and necessary expenses
• Sec. 212 – Expenses for production of Income – for
individuals:
1) Production/collection of income,
2) Management/conservation/maintenance of
property held for production of income, and
3) Connection with determination, collection, or refund
of any tax
16
Sec. 183 – Activities Not Engaged in for Profit
• Individual or S Corp – If NOT engaged in for Profit
there is NO deduction
• Exceptions:
– Deductions allowed without engagement for profit
– Deduction equals to deductions allowed if FOR PROFIT,
if gross income exceeds deductions allowed without
engagement for profit
17
Presumption
• Profit in 3 out of 5 years
• Profit 2 out of 7 years - Horse Business
• Presumed Activity for Profit
• Unless IRS establishes to the contrary
18
9 Factors To Consider
1. Manner taxpayer
carries on activity
5. Success with similar or
dissimilar activities
2. Expertise of taxpayer
or advisors
6. History of income/loss
7. Occasional profits
3. Time and Effort
8. Financial status
4. Expectation of Asset
appreciation
9. Elements of personal pleasure
or recreation
19
Factors to Determine if Activity Engaged In for
Profit
• Do time and effort indicate intent for profit?
• Do you depend on income from activity?
• Are losses due to circumstances out of your control or due to startup expenses?
• Have you changed operations to improve profitability?
20
Additional Factors
• Is your knowledge adequate to make this a profitable activity?
• What about profit in the past with similar activities?
• Was there a profit in some years?
• Any anticipation of profit in future from asset appreciation?
21
Practitioner Alert
• Activity is “presumed” for profit if:
• Profit in at least 3 of last 5 years
• Includes current year
• Profit in at least 2 of last 7 years if horses
22
If Activity Not for Profit
• Losses not used to offset other income.
• Losses occur when expenses exceed income.
• Limit applies to:
Individuals
Estates
S Corporations
Partnerships
Trusts
NOT C Corps
23
Allowable Hobby Deductions
Under IRC 183
• Activity NOT carried on for profit
• Allowable deductions cannot exceed income
24
Deductions for Hobby Activities
• Schedule A, Form 1040
• Deduct in following order:
1. Full deduction for home mortgage interest and taxes
2. Deductions not resulting in basis adjustment, advertising,
insurance premiums and wages may be taken to extent gross
income is more than deductions under 1
25
Deductions for Hobby Activities
3. Deductions that reduce basis taken last
Depreciation and Amortization
Only to extent gross income is more than deductions taken
in step 1 & 2
26
History in a Snap Shot
• Revenue Act of 1943 as IRC § 270
• Intension – limit individuals with multiple sources of income to
reduce overall tax liabilities
• IRC § 270 repealed by Tax Reform Act of 1969 for years after
12/31/69
• Replaced with IRC § 183
27
IRS Code § 183
• Applies to Individuals, Partnerships, S Corps and Trusts and
Estates
• Not C Corporations
• No IRC or Regulations defines – just guidance
• Historically a difficult issue
28
Generally
IRC allows deduction of expenses:
1) In trade or business – IRC § 162
2) Production or collection of income, management,
conservation or maintenance of property held for production
of income – IRC § 212
29
Honest Objective of Making a Profit
• Keanini v. Comr., 94 T.C. 41 (1990) citing
• Golanty v. Comr., 72 T.C. 411, 425 (1979), aff’d without published
opinion, 647 F. 2d 170 (9th Cir. 1981)
• Dreicer v. Comr., 78 T. C. 642 (1982), aff’d without opinion, 702 F.
2d 1205 (D.C. Cir. 1983)
30
Taxpayers Bear Burden of Proof
• Hendricks v. Comr. - 1994
• Comr. v. Groetzinger – 1987
• Bot v. Comr. – 2003
• Am. Acad. Of Family Physicians v. U.S. - 1996
31
Taxpayer MUST
• Devote time to business
• Honest belief profitable in the future
• Show what projected profit is to be
32
NOT Engaged In for Profit
• § 183(b) allows:
– Deductions allowable without regard to activity for profit
– Deductions for amounts allowable if engaged in for profit, to
extent of gross income remaining
33
Treas. Regs § 1.183-1(e)
Gross Income:
All income, including sales, exchanges or dispositions and all
other gross receipts
Reduced by COGS
Personal or nondeductible items will be excluded by IRS
Examiner.
34
Other Tax Return Items Affected
• SE tax
• AGI
• Deduction for Health
Insurance Premiums
• Personal exemption
phase out
• AMT
• Roth IRA Contributions
• Itemized Deductions
35
CAUTION
AGI affects many items:
Rental losses
Medical expense
Casualty losses
Miscellaneous deductions
Adoption expense credit
Interest on education loans
36
AMT Alert
Problem with Code § 183
Many not-for-profit expenses are reported on Schedule A –
Miscellaneous
Not deductible for AMT purposes
37
Treas. Reg. § 1.183-2(b)
•
9 Factors cited in Reg. – non-exclusive
1.
2.
3.
4.
Manner in which conducted
Expertise of taxpayer or advisor(s)
Time and effort expended
Expectation assets may appreciate in value
38
Reg. Continued
5.
6.
7.
8.
9.
Success of taxpayer in similar or dissimilar activities
Taxpayer’s history of income or loss with respect to activity
Amount of occasional profits, if any
Financial status of taxpayer, and
Elements of personal pleasure or recreation
39
How Many Factors Needed?
• No single factor controls
• Number does not control
• More weight given to objective facts than to taxpayer’s
statement of intent
• Dreicer v. Comr. - 1982
40
Review Questions for Self Study CPE:
Now’s the time to answer the first set of review questions.
Click here:
http://www.proprofs.com/quiz-school/story.php?title=NTc1NzQz
Profit in Early Years
• No blank check for future losses
• Profit objective in early years no guarantee not treated as notfor-profit in later years
• Daugherty v. Comr. - 1983
• Dennis v. Comr. - 1984
42
Presumption Under § 183(d)
Safe Harbor:
Engaged in activity for profit
3 out of 5 years
2 out of 7 for horse activity
43
Code § 183(e) - Election
Taxpayer is allowed to postpone determination of § 183(d)
presumption.
44
Code § 162
• Allows deductions for “trade or business” ordinary and necessary
expenses
• Bona fide business must exist
• Expenses appropriate to carrying on “trade or business” and not
capital expenditure. Not with respect to residence – exception
IRC § 280A
• Welch v. Helvering - 1933
45
Multiple Activities
• Treas. Regs. § 1.183-1(d)
• 2 or more separate activities not aggregated for not-for-profit
determination
• Unless sufficiently interconnected
46
Are Activities Interconnected?
• Based upon all facts and circumstances
– Degree of organizational and economic interrelationship,
– Business purpose for various activity, and
– Similarity of various undertakings.
Commissioner generally accepts taxpayers justification of
interconnected activities UNLESS cannot be supported and
each activity treated separately.
47
Taxpayer’s Subject to § 183
• Individuals – IRC § 183(a)
• S corporations – IRC § 183(a) – Treas. Regs. § 1.183-1(f)
• Partnerships – reflected in partnership’s distributive shares – IRC
§ 703(a)
• Trusts and Estates – IRC § 641(b)
48
C Corporations
The provisions of IRC § 183 do not apply to C corporations.
49
Election to Postpone Determination
• IRC § 183(e)
• Election to postpone determination of presumption until close
of 4th taxable year or 6th taxable for horse activities
• Following 1st taxable year engaged in activity.
50
If Election Made
• Taxpayer may file returns in the interim on assumption activity
is for profit
• Activity generating losses – not carried on for full profit
presumption period, taxpayer may elect to postpone
determination
• After filing of required returns – case file returned to IRS
examiner for determination
51
Making the Election
• Form 5213, Election to Postpone Determination as To Whether
the Presumption Applies That an Activity is Engaged in for Profit
• Used when taxpayers wish to postpone determination
• Election made by Partnership or S Corporation is binding upon all
persons
52
When to File
• Within 3 years after the due date of the return - No extensions
• For 1st year of the activity
• Not later than 60 days after notice from IRS proposing to
disallow deductions of activity
53
Practitioner Note
Form 5213 is rarely used by taxpayers until IRS proposes to
disallow the activity as not engaged in for profit.
54
Placing in Suspense
• Election made
• IRS will generally close case to suspense until end of
presumption period
• Upon filing of all returns for periods, case returned to IRS
Examiner for determination
55
If Taxpayer Wishes to File an
§ 183(e) Election
The IRS Examiner should:
1. Secure fully completed and properly signed Form 5213
2. Advise taxpayer of suspense process and to retain all
pertinent books and records for each of the presumptive years
56
Form 5213
• Election to Postpone Determination
1. Who Should File
2. When to File
3. Automatic Extension of Period of Limitations
57
What About the Statute of Limitations ?
• Filing of Form 5213 automatically extends statute for any
deficiency attributable to the activity
• Example: Activity subject to a 5 year presumption period
beginning in 2004 and ending 2008, the period of limitations
automatically extends to April 15, 2012 for all tax years in
presumption period.
58
Supporting Law Revenue Rulings
• Rev. Rul. 55-258 – Not engaged in for profit – taxable but not for
SE purposes
• Rev. Rul. 75-14 – FRV required to relative, deduction only for
expenses if itemizing
• Rev. Rul. 77-320 – Partnership, reflected in distributive share
• Rev. Rul. 2004-32 – OIH cannot be created to convert
nondeductible personal living expenses
59
Supporting Law Case Law
• Numerous § 183 Court Cases
• Some opinions favor taxpayers
• Others support the Government’s position
• Cases supportive of the taxpayer’s position should be used to
defend taxpayer’s position
60
Suggested Interview Questions for Each of 9
Relevant Factors
Practitioners should use to determine if activity is or is not
for profit:
Background and general description of the business.
How are the business records maintained?
61
More Interview Questions
What efforts are made in terms of attracting customers and
securing suppliers or products necessary for the business?
When is a profit expected?
62
Expertise of the Taxpayer/Advisors
• Background information about type of activity prior to start up
• Taxpayer’s relevant education
• Reliance on others in starting or developing business
• Research or extensive study regarding business
• Other life experience to prepare
• Related organizations and how long
63
Time and Effort Expended
• May be given more weight if no personal or recreation aspects
• Is this a full or part=time activity?
• Who is involved with the daily operations?
64
Expectation Assets will Appreciate
• Profit encompasses appreciation
• List assets used in the activity
65
Success of Taxpayer
• If taxpayer has engaged in similar activities in the past,
converting unprofitable to profitable, may indicate engaged in
for profit
• What other activities has the taxpayer had previous success?
66
Taxpayer’s History of Income/Loss
• Losses sustained beyond period customarily thought to bring
to profit, unless not due to control of taxpayer may indicate
not engaged in for profit
• Series of net income years would be strong evidence activity
engaged in for profit
67
Occasional Profits
• Large losses and only small profits = activity not engaged in for
profit
• Opportunity for substantial profit on highly speculative venture =
activity engaged in for profit
• What profits have been earned in any year?
• What amount of an investment has the taxpayer made in the
business?
68
Financial Status of Taxpayer
• No substantial income or capital from other sources = engaged
in for profit
• Personal or recreational elements = engaged in not for profit
• Does taxpayer have substantial income or capital from other
sources?
69
Elements of Personal Pleasure
• An activity will not be treated as not engaged in for profit merely
because the taxpayer has purposes other than solely to make a
profit
• Deriving personal pleasure from the activity is insufficient to
determine activity not engaged in for profit
• Was taxpayer involved or interest in this activity prior to
establishing it as a business?
70
Arlene – Case Study
• Sales of artwork in 2008
• 10 years before and years after 2008
• Gallery showings and efforts of Mary, a professional art
consultant recommendations
• Impressive witnesses, knowledgeable about art can testify about
Arlene’s abilities, reputation and potential
71
1998 through 2007 (Schedule C)
Year
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Expenses
$16,093
6,363
15,328
16,565
19,328
23,218
21,828
26,113
34,135
46,995
82,900
Gross Inc.
$ 7,586
1,280
8,790
8,192
11,042
4,363
400
1,325
18,299
5,975
7,700
Losses
$ 8,507
5,083
6,538
8,373
8,286
18,855
21,428
24,788
15,836
41,020
75,200
72
And, in 2008
Arlene reported an additional loss of $75,200
73
More Facts About Arlene
• Keeps checks and receipts for expenditures in labeled
envelopes
• Relies on Gordon Goodman, EA to review and determine
which expenses were business and to prepare income tax
returns
74
Arlene’s Living Arrangements
• Martha’s Vineyard in warmer months
• New York City rest of year – traveling between and elsewhere at
various times
• Rents small studio/apartment and two separate rooms in NYC
hotel
• Rooms not connect to apartment
75
Office In Home
• Uses portion of studio/apartment as living area and rest as
studio/work area
• Two other rooms as storage space for art
• Does not shop or socialize, spending most of her time working on
creating art, producing and promoting it
• Apartment is filled with her art
76
More About Arlene
• Due to toxic plastic resin needs to work in well-ventilated
space
• Rents loft in NYC for toxic material use as well as to store art
work
• She also rented another loft to store her paintings
77
Cost
Rent at hotel
Rent – 2 other rooms
Annual cost
Disputed cost
EA took 50% as business
Plus rent for 2 other rooms
Loft rent
Warehouse storage
No rent for Martha’s Vineyard
$ 400.00
$ 550.00
$ 11,400
$ 6,339
$ 1,092
$ 4,754
$ 6,175
$ 819
78
Other Expenses
• Insurance on artwork
• Liability insurance on apartment
$ 1,000
$ 30
• Purchase of Volvo station wagon for $18,750 on 6/11/08 –
used in business
• Previously used older car for same business purposes –
delivery, supplies, etc
79
More Expenses
• Insurance and parking space in NYC garage
• Older car moved to Martha’s Vineyard
• Volvo in NYC
• Insurance carried on both cars
80
Arlene’s Deductions
• Parking
• Automobile expenses
• Insurance on both cars
• Depreciation
$
$
$
$
1,214
1,257
3,470
4,688
• No tentative investment credit of $750 on Volvo taken
81
Analysis of Depreciation
• $627 for a $4,181
Computer
– All acquired in 1984
• $112 for upholstery on
furniture in NYC
apartment
• $427 in tentative
investment credit, but
did not use
• $46 for a $307 humidifier
• $5 for typewriter and $23
for unidentified item,
acquired before 2008
• $15 for telephone
82
There was More
• Contract labor paid
• Materials
$2,304
$5,970
• Professional services
Mr. Goodman, EA – 8 years
$8,169
83
And Finally
• Entertainment - $1,629
• Studio expense - $450
• Travel - $3,334, Egypt
$2,000, other $1,334
including ferry trips &
travel to Martha’s Vineyard
• Telephone - $1,372
• $10 per month allocated of
telephone for personal use,
deducting $1,252, including all
long-distance.
• Advertising - $74
• Dues and publications - $176
• Freight - $12
84
Let Us Not Forget
• Interest - $50
• Publicity Photos - $1,023
• Office expense - $98
• Credit card fee - $20
• Repairs - $125
• Taxis - $305
• Xmas and gifts - $189
85
IRS Determination
• 2006, 2007 and 2008 – Activities not engaged in for profit
• Disallowed all Schedule C deductions to extent they exceeded
her gross receipts
86
IRS Findings
• Receiving director’s fees and dividends, no longer dependent on
artistic activities
• Long history of losses
• Great personal pleasure derived from creating artwork and
seeing it displayed
• Income from other sources enabled her to pursue art career
87
Conclusion
• Arlene is sculptor and painter
• Worked full time as an artist for many years
• Engaged in artistic endeavors all adult life
• From 1959, when divorced from husband, through 1974,
supported herself entirely with income from artistic endeavors
88
Arlene
• Sold art work and taught classes for family owned company
• After death of mother became BOD member, earning Director
fees in 1975
• She received $63,000 in cash plus stock
• In 1984, received $559,875 in partial liquidation of her stock,
continuing to receive dividends
89
Arlene Then …
• Was not dependent upon the sale of her art work for her
livelihood
• Obtained a number of fellowships at artists’ colonies
• From the early 1970s through the early 1980s she was awarded
13 fellowships and 2 awards in recognition of her potential as an
artist
90
Art Displayed
• 1973-1984 work was in numerous exhibitions at museums and
art galleries
• Displayed where art sold for a profit
• Gallery showings in the 1970’s, 1978 and 1984
• Shown in galleries and museums, after the year in issue
91
Arlene’s Art Work
• Exhibited with very financially successful artists
• Required she contact galleries and museums to have work
accepted for exhibition
• Word of mouth, showings and exhibitions, reviews by art critics
and advertising efforts, reputation spread
• Museums sent invitations to view and Arlene held private
showings at her apartment in NYC
92
Art Activities for Profit
• Section 183 allows deductions
• Ordinary and necessary if not engaged in for profit to extent of
gross income, less amount allowable regardless of whether
activity not engaged in for profit
93
Considerations
• Arlene has shown pursuit of artistic activities with objective of
making a profit
• Test is “actual and honest objective of making a profit”
• Expectation might not have been reasonable but objective to
make a profit
• All considerations made
94
Factors Pointing to Profit Objective
• Improving skills
• Time devoted
• Fellowships for artists
• Did not require lavish
lifestyle
• Promotion of work by
herself
• Promotion of work by
others
• Consistently sold art
• Personal pleasure not
sufficient
• History of losses less
persuasive in art field than
others
• Record is replete with
evidence of showings and
exhibitions of work as
result of her efforts to
promote
95
While Not Selling as Much as Hoped
• Arlene sought recognition and profit, maintaining large inventory
• Arlene will enjoy greater financial benefits, having much success
and recognition and who wants to sell and intends to make a
profit
• Unlike Porter v. Commissioner – 1969-288, the taxpayer did not
sell much art and only for small amounts over a 10-year period
96
Further Considerations
• Arlene, a lifelong artist
• Sold much more art for significant amounts
• Is nationally recognized with work shown and exhibited in wellknown galleries
• Impressive listing of witnesses
• At any time, Arlene might become more commercially successful
and earn enough to cover losses
97
Review Questions for Self Study CPE:
Now’s the time to answer more review questions.
Click here:
http://www.proprofs.com/quiz-school/story.php?title=NjA0MjE3
Final Conclusion
• I conclude that she engaged in the activity with “the actual
and honest objective of making a profit”.
• Based on Stella Waitzkin v. Commissioner, T.C. Memo, 1992216
99
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