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Deductibility of expenses under the business/hobby rules.

Individuals engaged in certain endeavors cannot deduct their losses if the endeavor is "not engaged in for profit." The presumption of a profit motive can be achieved if the activity shows a profit in three years out of five (two years out of seven for horses). Even with three profitable years the IRS can still take the position that the activity is a hobby. However, the three profitable years create a presumption that the taxpayer has a profit motive unless the Service can prove otherwise.

If the taxpayer's activity does not show a profit in three years out of five, the taxpayer will have to rely on Regs. Sec. 1.183, which sets forth specific factors to be considered in the determination of profit intent. The following factors are to be considered in making the determination of the nature of an activity: * The manner in which the activity is carried on (e.g., if the activity is conducted in a businesslike manner). * The expertise of the taxpayer or his advisers. * The time and effort expended. * The expectation that the assets of the activity will appreciate in value. * The previous success of the taxpayer in the conduct of similar activities. * The history of income or losses from the activity. * The relationship of profits earned to losses incurred. * The financial status of the taxpayer (e.g., the fact that the taxpayer does not have substantial amounts of other income may indicate that the activity is engaged in for profit). * Elements of personal pleasure or recreation in the activity.

Literally interpreted, the general presumption of a profit motive applies only to the third profit year and all years thereafter within a five-year period beginning with the first profit year. Assume, for example, that a taxpayer is confronted with annual profits in 1989 through 1991 and losses in 1987, 1988, 1992 and 1993. The burden of proof rests on the IRS, therefore, for the years 1989 through 1993 to show that the taxpayer did not have a profit motive. The first two years of the operations, however, are not protected under the general presumption by the profit years of 1989 through 1991.

It is possible to combine a special presumption with the general presumption and to shift the burden of proof for the years 1987 and 1988 to the Service by filing Form 5213, Election To Postpone Determination as To Whether the Presumption That an Activity Is Engaged in for Profit Applies. This election can be made only once per venture and is effective for only the first five years of a new operation. The problem with this approach is that the IRS may still disallow the losses from the activity by looking at all the facts and circumstances. This possibility is enhanced by the filing of Form 5213, and this election should usually not be made. Rather, strict adherence to the points listed in Regs. Sec. 1.183 seems to be a less risky approach to protecting losses during the early years of a venture.

Court decisions have considered research by the taxpayer and general knowledge about the activity to be important factors. General involvement on the part of the individuals engaged in the endeavor is quite important and physical involvement has been noted by the Tax Court as favorable on several occasions.

The regulations specifically state that profit intent is influenced by the amount of profit and losses. An occasional small profit, such as three out of five years, may not be sufficient to deter the Service's scrutiny if large loss years are present.

The commingling of the taxpayer's personal checking account with the taxpayer's business affairs is an avenue to trouble. Courts take this as an indication that the taxpayer did not conduct the activity in a business-like fashion.

Application of the hobby expense rule

Novices in the entrepreneurial area often believe that no deductions can be taken if the activity is not a business. Hobby expenses are deductible, but only to the extent of income derived from such activities. An activity that is classified as a hobby does not generate a tax loss that can be used to offset other taxable income. The tax rules further penalize the taxpayer by providing that expenses must be deductible in the following order. 1. Expenses of the activity that would otherwise be deductible as itemized deductions. 2. Activity expenses that would be deductible if the activity was a business but do not affect the basis of property. 3. Activity expenses such as depreciation that affect the basis of property.

Most importantly, however, the second and third tier activity expenses are miscellaneous itemized deductions deductible only to the extent they exceed 2% of adjusted gross income (AGI). See the example above.

The phaseout of itemized deductions would, of course, only worsen the situation. In 1993, the itemized deductions otherwise allowable are reduced by 3% of the AGI in excess of $108,450. In the example, if there are no other itemized deductions, the $14,000 of deductions is reduced by $5,747. The $18,000 economic loss is, therefore, transformed into an increase in taxable income of $11,747. This represents the difference between the $20,000 of gross income and the allowed itemized deductions of $8,253 ($14,000 - $5,747). From Russell H. Hereth, MBA, CPA, Associate Professor of Accountancy, and John C. Talbott, DBA, CMA, Professor of Accountancy, Wright State University, Dayton, Ohio

Example: Hobby Expense Rule

D, a physician, decides that his tremendous endurance could be put to excellent use in the show horse ring. In 1993 he financed the purchase of his horse with a home equity loan. During the year, he won $20,000 in awards and has $280,000 of AGI, excluding his winnings.
Gross income from showing $20,000
Interest expense 10,000
Maintenance costs 13,000
Depreciation 15,000
Total expenses 38,000
Economic loss $(18,000)

If the activity is a hobby, D must include the $20,000 of winnings in gross income, thereby increasing his AGI to $300,000. Disregarding the phaseout rules for itemized deductions, the $10,000 of interest is deductible and would have been deductible no matter what D had done with the home equity proceeds. (Home equity interest would not be deductible if the proceeds were used to purchase tax-exempt securities.) Ten thousand dollars of the maintenance costs (the difference between the gross proceeds and the deductible interest expense) are a miscellaneous itemized deduction; the remainder of the maintenance costs and all of the $15,000 of depreciation are not deductible. Assuming D has no other miscellaneous itemized deductions, only $4,000 of these deductions ($10,000 - (2% x $300,000)) will generate any tax savings. In essence, the vagaries of the hobby loss rules have transformed an $18,000 economic loss into a $6,000 increase of taxable income.

Gross income $20,000

Deductions allowed:
Interest $10,000
Miscellaneous 4,000
Total expenses deductible 14,000
Increase to taxable income $ 6,000
COPYRIGHT 1993 American Institute of CPA's
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Article Details
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Author:Talbott, John C.
Publication:The Tax Adviser
Date:Sep 1, 1993
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