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While
the Tax Code never uses the word "hobby," the rule is designed to
prevent taxpayers from writing off the cost of conducting recreational,
pleasure, or other hobby activities. The rule was created with
activities such as dog breeding, coin collecting and other collecting
activities in mind, but is not limited to these activities. This rule
is particularly relevant to sideline activities, many of which do not turn a
profit.
Generally,
losses from an activity are deductible in full (subject of course to other
limitations in the tax law) if the activity is engaged in for profit.
If the activity is not engaged in for profit and the hobby loss rule
applies, then all income must, of course, be reported, but deductions can
only be claimed to the extent of the income.
Hobby
loss deductions are claimed as miscellaneous itemized deductions on Schedule
A subject to the 2% of AGI limit. They are not claimed on Schedule C,
used by sole proprietors to take regular business deductions, or on Schedule
E, used by owners of pass-through entities. Unused losses from
activities not engaged in for profit are lost forever; they cannot be
carried forward.
The
hobby loss rule prescribes an order for taking allowable deductions to
offset income from the activity. First, income is offset to the extent
of otherwise deductible items without regard to profitability of the
activity, such as real estate taxes. The second category to offset
income is business expenses that do not affect basis, such as utilities,
maintenance and supplies. Finally, income is offset by depreciation.
The
hobby loss rule says that if the activity in not engaged in for profit, then
losses are limited to income from the activity, as we just explained.
So what is a profit motive? This is largely a subjective analysis.
However,
a taxpayer is presumed to have a profit motive if there is profit in at
least three of the last five years, including the current year. In the
case of horse-related activities, the presumption period is two of the last
seven years.
However,
even if there are insufficient profits to support this presumption, a
taxpayer may demonstrate by facts and circumstances that there is a genuine
profit motive. There has been considerable litigation through the years on
the question of profit motive. Here are the key factors that courts
have relied on in making a determination of profit motive. The first
two are difficult for a sideline business owner to prove:
-
Spending
considerable time and effort on the activity
-
Relying
on income from the activity for a livelihood
-
Taxpayer's
financial status
-
Elements
of personal pleasure or recreation derived from the activity
-
Cause
of the losses
With
these factors in mind, let us focus on a few court decisions concerning
sideline businesses to demonstrate how the facts actually play. For
example, in one case a CPA tried to deduct the expenses of his activity as
an artist. The court held that he lacked profit motive. His
records consisted of a shoebox full of receipts and he did not have a separate
business bank account. Also, he did not try to change his operations
to make a profit.
In
another case, a lawyer's sideline activity of running a mail order art print
business was also held to lack of profit motive. He had no evidence
that he ran the activity in a businesslike manner, and his attempts at
marketing were minimal.
A
doctor's automotive restoration business lacked a profit motive; it was not
conducted in a businesslike manner.
An
investment adviser lacked a profit motive for his off-road pickup truck
racing endeavor. He did not try to obtain sponsors, which is the only
way to make a profit in this activity.
In
another case, teachers could not deduct expenses of their homemade craft
items sold at craft shows because they lacked a profit motive. They
had losses in five straight years and did not attempt to change operations
in order to limit losses or turn a profit.
In
yet another case, a chiropractor could not deduct losses from horse breeding
activities. He did not prepare any financial projections showing how
he intended to make a profit, he did not keep invoices for the horses that
were sold, and he had no expertise in the horse industry.
However,
do not think that taxpayers never win. For example, a tax attorney
recently was held to have a profit motive with respect to purchasing a
painting then returning it to the seller after learning that it was not
authentic. He claimed that his sideline business was buying and
selling art. His expertise in obtaining financing for art purchases
was established, and he did not act out of personal pleasure.
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