Hobby or hard work? Don't let the IRS decide.

It is not uncommon to have a client who, in addition to having a regular job, seeks ways to earn additional income, either by obtaining a part-time job or by becoming self-employed. If clients choose the self-employment route the hobby loss rules may need to be considered when a loss results from the activity.

Although the idea of a hobby is generally associated with fun and recreation, the element of personal pleasure derived from engaging in a hobby is just one of the factors used to determine the existence of a profit motive.

Sec. 183(a) denies loss deductions if an activity is not engaged in for profit. Regs. Sec. 1.183-2(b) sets forth the following nonexclusive list of objective factors relevant to the determination of whether an activity is engaged in for profit: [] The manner in which the taxpayer carries on the activity. [] The expertise of the taxpayer or his advisers. [] The time and effort expended by the taxpayer in carrying on the activity. [] The expectation that the assets used in the 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 earned. [] The taxpayer's financial status. [] The elements of personal pleasure or recreation involved in the activity.

The Tax Court has considered these factors in a vast number of cases, concluding that more weight may be given some factors, while other factors may not be applicable in a particular setting. Cases abound disallowing losses when the taxpayer engages in recreational pursuits such as horse and dog breeding, drag racing and yachting.

But even if there is no clear recreational enjoyment, the Service has challenged losses derived from nonrecreational, professional activities. Recently, however, a taxpayer who incurred a series of losses from a professional activity succeeded in persuading the Tax Court that the activity was engaged in for profit.

In Westphal, TC Memo 1994-537, the taxpayer opened a solo law practice. Westphal typically worked eight hours a day, five days a week and continued to develop her legal skills by attending various seminars and professional luncheons, as well as participating in networking activities through community and civic organizations. Westphal preferred to work in the areas of taxation and estate planning, but accepted other client matters she felt competent to handle. Because she was a relatively new attorney, she often did not bill her standard rate, which increased from $75 to $100 over the course of her practice.

The law practice never made a profit, and by 1988 (after four years in practice) Westphal began to search for a position with an established law firm. (She was also away from her practice for a period of time because her father had become ill.) Nevertheless, she continued to serve her active client list, but did not operate her practice with the same active networking style as she had previously done.

For the 1989 and 1990 tax years, the IRS disallowed losses on the grounds that her law practice was not entered into with a profit motive. The Tax Court disagreed, and allowed the losses in full. Citing Regs. Sec. 1.183-2(b), the court noted that she engaged in her law practice in a businesslike manner, continued to develop her expertise in her profession, and spent substantial amounts of time on legal matters.

The Westphal decision may provide some guidance to taxpayers who engage in self-employment activities related to their regular employment. Lawyers, accountants, consultants and other professional should not have to contend with the "personal pleasure" element of the regulations. Yet careful attention should be paid to the other elements of the regulations, including the maintenance of accurate books and records. For example, in Sloan, TC Memo 1988-294, losses were denied to an attorney who worked full time for the Department of Justice as a computer analyst. Sloan lived in Washington, D.C., and claimed deductions for a law office he had set up in a neighboring community which he visited only on weekends. The court found that he failed to keep detailed business records, did not charge clients for services, and did not socialize within the community or exert any other effort to generate business. In Owen, 23 TC 377 (1954), losses for the maintenance of an office in North Dakota were denied for an attorney who was employed in Washington, D.C. Owen had not been in North Dakota for two years and received no income from the practice of law. In Cohen, TC Memo 1984-237, an attorney who closed an unsuccessful practice was denied deductions for losses incurred five years after the practice had been terminated.

An added benefit of operating a related Schedule C business may be the opportunity to shift deductions from the miscellaneous itemized category to business expenses. Expenses related to self-employment activities should be reported on Schedule C rather than as a miscellaneous itemized deduction subject to the 2% floor. If the employment and self-employment activities are similar in nature, expenses relating to the self-employment activity, but which also may provide an ancillary benefit to the employment activity (such as trade journals and unreimbursed continuing education), may be deducted on the Schedule C as a business expense. From Mary Ellen Potter, CPA, Cleveland, Ohio