The “hobby loss” rules of Internal Revenue Code Section 183 are commonly overlooked limitations that restrict the amount of loss a taxpayer may claim from an “activity not engaged in for profit” – i.e., a hobby. The definition of these activities is framed in the negative; a hobby is any activity other than those for which losses are allowed under Section 162 (ordinary and necessary business expenses) and Section 212 (investment expenses).
Generally, Sections 162 and 212 business and investment expenses can not only offset the income generated by those activities, but net losses over and above this income can offset other, unrelated income, and can often be carried forward (and sometimes backward) to offset income in other years. However, Section 183 hobby expenses are limited to the amount of revenue earned from the same activity, and any excess generally is completely lost. While the taxpayer can generate enough hobby expenses to break even or zero out hobby revenues in a given year, it will be barred from claiming a valuable tax loss and cannot use the excess deductions in future years.
The distinction between hobby losses on the one hand, and business and investment expenses on the other, is the existence of a profit motive for the underlying activity. Profit motive is determined by examining the facts and circumstances surrounding the activity. The U.S. Supreme Court, in Commissioner v. Groetzinger, said that “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. . . . A sporadic activity, a hobby, or an amusement does not qualify.” The burden of establishing that a business activity is not hobby is a on the taxpayer. However, under Section 183(d), if an activity turns a profit in 3 out of 5 years (or 2 out of 7 in circumstances involving horse training, breeding, or racing), the intent of profit is presumed to exist for the first year of profit and the following 4 years.
The U.S. Treasury has adopted regulations under Section 183 to aid in the determination of whether a loss is a hobby loss. Regulation §1.183-2 identifies the following of nine factors that should be considered in evaluating whether a business is a hobby or not:
- Manner in which the taxpayer carries on the activity
- The expertise of the taxpayer or his advisors
- The time and effort expended by the taxpayer in carrying on the activity
- Expectation that assets used in activity may appreciate in value
- The success of the taxpayer in carrying on other similar or dissimilar activities
- The taxpayer’s history of income or losses with respect to the activity
- The amount of occasional profits, if any, which are earned
- The financial status of the taxpayer
- Elements of personal pleasure or recreation
In the IRS Audit Guide, the IRS instructs its field examiners that they must examine each of the nine factors in the Regulations, providing a long list of suggested questions to be asked, such as “does the taxpayer have a license to operate?,” “did the taxpayer stand to lose or have expenses beyond what normally incurs?,” “are books and records accurate and complete?,” “are books comparable to types of books kept by others in the same activity?,” “are financial statements prepared?,” “what is the maximum profit expected?,” and “when will profit occur?,” among others.
The Tax Court engaged in a lengthy analysis of the nine factors in T.C. Memo 2012-96, examining famed lawyer F. Lee Bailey’s yacht rental activity, and disallowed the deductions associated with the activity. Bailey claimed to be engaged in a “refurbishment and selling enterprise”, when the record showed he only purchased and refurbished one yacht, had no expectation that the yacht would ever appreciate in value, was never involved in a similar activity, and was unable to establish the amount of time spent in connection with the activity.
While certain elements of the hobby loss factors are out of the taxpayer’s control, others can be addressed by taking care to treat the activity as a business. Keeping regular books and records, preparing financial statements, and properly documenting other activities in support of the profit-seeking motive will go far in supporting a claim that an activity is a business and not a hobby.