During the pandemic, we’ve had a lot of clients pick up an income producing hobby. Having hobby income does impact your taxes. There is the issue with sales tax and that is a confusing mess of thousands of tax jurisdictions. But today, we are going to focus on income taxes and how your hobby (and related losses) may qualify to be treated as a business.
This is important as business losses are deductible, but hobby losses are not.
Three out of Five and Two out of Seven
Let’s get this out of the way quickly. If in an activity, you have income in excess of expenses for three or more taxable years in the period of five years that ends with the year under examination, there is a presumption the activity is engaged in for profit. A bit of trivia is that the rule is two out of seven in horse cases – the Senator who got that modification added in was from Kentucky. Here is the important takeaway from all this. Three out of five and two out of seven never show up in the case law. And taxpayers win cases when they have had a string of losses as long as 20 years.
The Factors
The regulations list nine factors to be considered in determining whether an activity is engaged in for profit. It cautions us that there might be other factors, but more than 300 decisions in nearly 50 years have not identified any. Here are the factors:
- Manner the taxpayer carries on the activity;
- The taxpayer’s expertise or his advisers’;
- The time and effort the taxpayer expends in carrying on the activity;
- Expectation that assets used in activity may appreciate in value;
- The success in carrying on other similar or dissimilar activities;
- The taxpayer’s history of income or losses with respect to the activity;
- The amount of earned occasional profits, if any;
- The financial status of the taxpayer;
- Elements of personal pleasure or recreation.
In fact, in all decisions when the factors are enumerated, there is is one determinative factor –with one exception – the first factor – manner the taxpayer carries on the activity – is determinative. If the taxpayer wins on the first factor, they win. Otherwise, they lose.
One Factor to Rule Them All
As it turns out, though, if you win on the first factor, you win. And being business-like is something that is totally under your control and something we can help you with. There are five subfactors to consider. They are:
- Complete and accurate books and records;
- Carried on in a manner substantially similar to a profitable undertaking;
- Change of operating methods, adoption of new techniques, abandonment of unprofitable activities;
- Business plan;
- Advertising.
Cases
One of the things that drew me to hobby loss cases is that I find them so amusing. And of course, the most amusing cases are usually taxpayer losses.
Consider Joshua Pingel who ran through $40,000 globetrotting purportedly to write a travel blog called “The World in My Nutshell.” Among the many problems he faced in arguing his case was that he did not talk to experts until after he blew through the travel money.
Maurice Dreicer lost twice in Tax Court. But it is his in-between win in the D.C. Circuit that is important. The ruling is that when a taxpayer has an actual and honest objective of profit, it does not matter that the prospect of achieving it “may seem dim.” If an agent raises the issue of it being improbable that your lavender farm will succeed, you need to hit them over the head (figuratively) with this decision.
Conclusion
It is fine to talk a physician client out of going into horse breeding or raising cattle, but if they are going to do it anyway, we don’t not try to talk them out of claiming the losses. Rather, we talk to them about what they need to do to beef up their chances of winning an audit of their cattle ranch. Your hobby may not be an expensive or expansive, but the same rules apply.
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