• How to Defend Against IRS Claim of Hobby Losses

    By E. Pete Lewis

    07-05-2016

    If you're a high income business owner in the United States with net operating losses in three out of five consecutive years, the IRS is poised to disallow your tax return losses as "hobby losses". This is a target area that may spark new IRS audits.

    After several years of loose scrutiny of the "Hobby Loss Rules" {IRC Sections 183(a) and (d)} the Treasury Inspector General for Tax Administration (TIGTA) decided that the IRS needs to impose closer scrutiny. After conducting an audit of IRS records the TIGTA concluded that approximately $70.9 million of tax revenue may have been lost in 2013 from non-compliance.

    On April 12, 2016, the TIGTA issued a report which advised the IRS Small Business/Self Employed Division to "make use of research capabilities... and required filing checks" to conduct a more aggressive identification of high income business owners who show patterns of losses that may be identified as "hobby losses" activities.

    "Hobby Loss Rules" disallow tax deductions for net operating losses resulting from business activities that have incurred losses for any three out of five business years (two out of seven for breeding, training, showing or racing of horses). The purpose of this rule is to prevent taxpayers from sheltering income with non-business hobby activities. The test for hobby activities is a lack of profit motive.

    The good news is that upcoming IRS audits will be decreased. The IRS reported that audits of individuals for fiscal year 2015 were 0.84%, partnership returns were 0.51%, Subchapter S Corporations were 0.40% and large corporations were 11.15%. These low audit rates are partly due to a reduced IRS labor force.

    The IRS "hobby loss" initiative means that it will review prior year tax filings then propose adjustments to your tax returns. These adjustments could morph into correspondence audits.

    What target group is affected?

    Let's say you have a start-up business which has not been generating sufficient income for three out of five years. And since your business is not self-sustaining you've been forced to work full-time (or part-time) for another employer. Your annual wages are about $100,000. You are at risk.

    So how do you defend against allegations of "hobby losses"?

    The key issue here is profit motive. And profit motive is not defined by earnings. It is defined by intentions which translate into the amount of time, expertise and investment in a particular activity. It is understood that profit is certainly susceptible to poor economic variables. And the absence of multiple year profits is not per se, a presumption that the activity is not engaged in a profit (Treasury Regulation § 1.183-2).

    Here are some things to consider.

    • It is crucial for business owners to devote significant hours to their businesses. How many hours are considered significant? Consider that there are approximately 2,080 business hours in a year. If your company is your only source of income, you may not be at risk. But if you are conducting multiple business activities and are a full-time employee elsewhere, you may be a prime target. To insulate yourself you should devote at least 750 hours a year to running each business.

    Why 750 hours? This number is derived from the minimum hours required to avoid classification under the passive activity rules of IRC Section 469. Passive activity rules also disallow deductions from net operating losses against ordinary income. However, if more than 750 hours are devoted to a business activity, the IRS considers participation to be "material" or non-passive. Passive activity rules were initially designed to prohibit non-working investors from sheltering ordinary income by investing in ventures which consistently produce losses.

    • Document your business hours, types of activities and business expenses. It's advisable to keep a log.
    • Every business, especially corporations should have a Board of Directors. Board meetings should be held at least annually, but preferably more frequently. Major decisions regarding capital purchases, sales penetration, hiring and firing should be documented and validated.
    • Research should be conducted and documented to verify unfavorable market conditions which may have led to business losses. Such parameters as low market penetration, government regulations (if applicable) and research and development costs can justify your net operating losses. Don't worry about looking like a failed businessman. And you very well may be involved in a failed business venture. But such a predicament does not mean that you are a gamer or engaged in a hobby.
    • Let the business purchase investment assets. If there are expectations that assets used in the business may appreciate in value, the activity may lend creditability as a business versus a hobby.
    • The amount of profits in relation to the amount of losses over the years and the amount of investment in the activity may indicate intent.
    • Small profits one year and large losses in other years may be interpreted as hobby activities.
    • Conversely, substantial occasional profits and frequent small losses may be interpreted as business activities.
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  • The information provided in this article is for general information purposes only. The information is not intended to be comprehensive or to include advice on which you may rely. You should always consult a suitably qualified professional on any specific matter.

E. Pete Lewis

E. Pete Lewis is an Adjunct Professor and Chairperson of Accounting and Finance for the DePaul University, School of New Learning, University of Phoenix-on ground, School of Business and Aurora University in the City of Chicago, Illinois USA. Mr. Lewis holds an MBA in finance and is a Certified Public Accountant and Enrolled Agent Admitted to Practice Before the IRS.

Mr. Lewis has more than 35 years of tax planning experience working in public accounting, legal and corporate environments. He is a Tax Consultant and principal in Lewis & Associates Tax Planning, Inc., a U.S. based tax planning firm. His firm concentrates on IRS debt resolution and tax minimization strategies for small and medium sized U.S. based companies.

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