The IRS operates with a different set of rules when auditing a return to determine if the losses claimed on Schedule C are those of a business or a hobby.
A hobby is any activity that a person pursues because they enjoy it and with no intention of making a profit. People operate a business with the intention of making a profit. While intentions do matter, they are not by themselves determinative as to whether an individual has a business for profit or are pursuing their lifetime dream in the form of a hobby.
Complicating matters are that some individuals engage in hobby activities that create a source of income for them. When does that hobby become a business? Others may start a business and have a history of losses – when does that business become a hobby in the eyes of the IRS?
IRS Audit Bells
Tax practitioners often view the IRS’s hobby loss rules as an audit program to limit individual taxpayers using hobby losses as a tax shelter to offset other sources of income. Although the IRS is very secretive about what factors it uses to audit taxpayers, it is reasonable to assume that the following scenario would be one example of when the IRS would select a return for a hobby loss audit.
Scenario: An individual has a Schedule C that has reported more than incidental losses for multiple years and such losses were used to offset other sources of income. The reported losses do not decrease, or perhaps increase each year. The listed activity of the business is one that the IRS could associate as being a hobby – such as horse racing, a winery, sailboat charters, and collecting and selling antiques. Such a list could almost be endless. If the annual losses are a few hundred dollars, the likelihood of an IRS audit is probably remote. However, if the losses are in the thousands of dollars, the odds of an audit exam would undoubtedly increase. The taxpayer’s listed occupation on the Form 1040 could also come into play. If an IT W-2 technician is reporting significant losses from a horse farm, the IRS would likely question if that individual has the background and experience to have a profitable business.
The IRS has established factors taxpayers must consider when determining whether their activity is a business or hobby. Tax preparers are also advised to consider these factors if a taxpayer wishes to claim a loss on their Schedule C.
These factors are whether:
- The taxpayer carries out activity in a businesslike manner and maintains complete and accurate books and records.
- The taxpayer puts time and effort into the activity to show they intend to make it profitable.
- The taxpayer depends on income from the activity for their livelihood.
- The taxpayer has personal motives for carrying out the activity such as general enjoyment or relaxation.
- The taxpayer has enough income from other sources to fund the activity.
- Losses are due to circumstances beyond the taxpayer’s control or are normal for the startup phase of their type of business.
- There is a change to methods of operation to improve profitability.
- Taxpayer and their advisor have the knowledge needed to carry out the activity as a successful business.
- The taxpayer was successful in making a profit in similar activities in the past.
- Activity makes a profit in some years and how much profit it makes.
- The taxpayer can expect to make a future profit from the appreciation of the assets used in the activity.
All factors, facts, and circumstances with respect to the activity must be considered. No one factor is more important than another.
Looking at the IRS factors, taxpayers with continued losses would be wise to have a business plan that shows the eventual reporting of profits, document the activities of the taxpayer to adapt to actual business results to make the loss activity become profitable, maintain time logs to show how much time the taxpayer is spending on the activity, and consultations with business advisors on how to make the business profitable among other action steps.
If a taxpayer receives income from an activity that is carried on with no intention of making a profit, they must report the income they receive on Schedule 1, Form 1040, line 8.
IRS Audit Guide
The IRS issued Publication 5558 Activities Not Engaged in for Profit Audit Technique Guide Internal Revenue Code Section 183 on September 7, 2021. This is a must read for anyone planning for a potential hobby loss audit or actually being audited. When the IRS issues an audit guide, it is because it considers the issue of importance to the IRS and its ability to collect tax revenues.
The guide encourages agents to talk directly with taxpayers in person at their place of business. Many taxpayers make the mistake of speaking directly with the IRS agent rather than seeking representation. The IRS agent will be armed with this audit guide and its lead sheets with pointed questions to better enable the agent to prove, using the taxpayer’s own admissions, that the activity is a hobby. Armed with the taxpayer’s testimony, the IRS will generally prevail in its audit findings.
Taxpayers need be familiar with Code Section 183(d) presumption. The presumption is that unless there is profit in three out of five consecutive tax years or two out of seven in the case of horses, the activity is a hobby (and those reported losses are permanently lost) and not a business. In our years of representing taxpayers in hobby loss audits, those who did not meet this presumptive test can overcome it by citing applicable case law supporting the audited taxpayer’s activities. This may require that the taxpayer go to IRS Appeals.
The Guide states that if the taxpayer qualifies for the presumption, the IRS can rebut that presumption. But the burden of proving that the activity is not engaged in for profit shifts to the IRS. Thus, the agent rebutting the presumption is unlikely, unless the agent believes the taxpayer manipulated income and/or expenses for the sole purpose of satisfying the presumption rule.
Tax Tip #1
Section 183 is one of the few areas the final outcome is often based on case law. The law is clear that a realistic expectation of profit is not required to sustain a loss. What is required is an honest objective to make a profit and the taxpayer’s ability to demonstrate that objective by behaving in a businesslike manner.
Tax Tip #2
If you start a business where losses are anticipated due to the start-up time it takes to make the business mature and profitable, or you have an existing business with a history of losses that the IRS has notified you that your are being audited, you should consider with an experienced tax professional who is familiar with IRS audits and the hobby loss rules.
If you would like to discuss your business or personal tax planning, tax preparation and other financial concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
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About F. Bryan Haarlander, EA, CTRS:
Bryan Haarlander is an IRS licensed Enrolled Agent and who owns and operates a specialized tax services firm serving clients in the western suburbs of Philadelphia, PA, which includes the cities of Chester Springs, Coatesville, Collegeville, Devon, Downingtown, Exton, Frazer, King of Prussia, Paoli, Philadelphia, Phoenixville, Pottstown, Radnor, Reading, Wayne, West Chester in Berks, Chester, Delaware, Montgomery and Philadelphia Counties, as well as clients in Delaware, New Jersey, New York and throughout the continental USA.
A Certified Tax Resolution Specialist, Bryan is well-known for his IRS tax resolution expertise and his book How to Resolve Your IRS Tax Debt Problems.