| IntroductionThis article provides guidance to those | | | | Losses that are excessive and unreasonable, but |
| concerned that their profit motivated trade or | | | | which offset income from other sources, are |
| business activities remain deductible, particularly in | | | | immediately suspected as recreational or |
| those cases where losses have been generated in | | | | hobby-related. The continuation of such |
| the past and/or are expected to continue to be | | | | unprofitable activities (when they have not proven |
| generated in the future.The 3-out-of-5 year rule | | | | successful in reducing losses or generating profits |
| and taxpayer misconceptionsThe Internal | | | | in the past) provides very strong evidence of the |
| Revenue Service (IRS) has established an | | | | absence of profit motive. However, increasing |
| administrative rule regarding their presumption of | | | | gross profits, even when combined with increasing |
| profit:An activity is presumed to have a profit | | | | expenses of operation, may provide sufficient |
| motive if it produces a profit in at least 3 of the | | | | evidence of profit motive.Credentials, publications, |
| past 5 tax years including the current year. | | | | previous successes in similar or related activities |
| -Publication 535: Business Expenses, IRS, p. 6.This | | | | or other evidence of expertise (or the hiring of |
| is merely an administrative rule used internally by | | | | experts) provides strong evidence of profit |
| the IRS. It does not have the effect of statutory | | | | motive. |
| law and it does not follow that an activity failing | | | | Generally, the more time and effort put into the |
| to produce a profit in at least 3 out of 5 years will | | | | activity, the greater the perception and |
| be presumed to be a not-for-profit activity. Yet | | | | presumption of profit motive. When a taxpayer is |
| many taxpayers have this misconception.No single | | | | employed in a non-related activity as well, it is |
| factor constitutes evidence of profit motive, | | | | useful to maintain some form of written evidence |
| although some have evolved from case law and | | | | of the dates and hours spent on the activity. |
| have been adopted by the IRS.What is a | | | | (Such logs need not be terribly detailed.) |
| hobby?A hobby is an activity not engaged in for | | | | Dependence or reliance on income from the |
| profit. The term hobby suggests an activity that | | | | activity implies an absence of hobby or |
| is personal and recreational in nature. It is unlikely | | | | recreational involvement, particularly when other |
| that an electrician would be concerned about | | | | taxable income items (e.g., salaries) are not |
| having his/her business classified as a hobby. | | | | significantly offset.The purchase of activity-related |
| Alternatively, a skydiving instructor, who also | | | | assets expected to appreciate implies investment. |
| engages in this sport for personal pleasure or | | | | Investment expenses do not warrant the |
| recreation, may be a more likely candidate for | | | | generation of allowable trade or business losses, |
| IRS scrutiny and hobby loss classification.10 | | | | but require capitalization or the accumulation of |
| determining factors for profit motive10 factors | | | | costs to eventually calculate the gain or loss from |
| are used to determine profit motive and include | | | | the investment when the sale of the asset takes |
| the following: | | | | place. Reclassification of the activity as |
| 1. Is the activity carried on in a business-like | | | | investment-related will result in the disallowance of |
| manner? | | | | (interim) operating losses.A checklist approach |
| 2. Does the time and effort expended on the | | | | Use the above, 10 factors, as a "hobby loss |
| activity suggest profit-motive? | | | | checklist" to review your exposure to hobby loss |
| 3. Does the taxpayer depend on the activity for | | | | or not-for-profit classification. Generally, a "yes" |
| his/her livelihood? | | | | response on all or most of the 10 factors |
| 4. Are losses due to circumstances beyond | | | | contained in this article would suggest clear |
| taxpayer control? | | | | compliance with a factor and overall support for |
| 5. Has the taxpayer modified operating methods | | | | the evidentially supporting position of profit |
| to improve profitability? | | | | motive. A "no" response on a factor identifies a |
| 6. Does the taxpayer (or advisors) possess | | | | weakness.Weaknesses should be pursued, if |
| expertise sufficient for success? | | | | possible, to upgrade the response to an |
| 7. Has the taxpayer experienced success/profits | | | | "uncertain" or "yes" response. Finally, an "uncertain" |
| in similar past activities? | | | | response should pursued by the taxpayer, with |
| 8. Has the activity generated a profit (and how | | | | the objective of upgrading or strengthening the |
| much) in past years? | | | | evidentiary requirements for this factor to a "yes" |
| 9. Can the taxpayer anticipate appreciation of | | | | response. Of course, if your self-employment |
| assets used in the activity? | | | | trade or business results in net earnings or |
| 10. Does the activity have elements of personal | | | | contributes to increased taxable profits, you need |
| pleasure or recreation?Evolution of the hobby loss | | | | not be concerned with this checklist.Summary |
| classificationThe above are factors that have | | | | These factors are only relevant to the |
| evolved from tax court cases and the need to | | | | self-employed taxpayer (1) with a tax loss from |
| ascertain the motives of taxpayers who were | | | | self-employment endeavors and only become |
| self-employed and using small business losses to | | | | critical (2) if audited by the IRS. However, to the |
| offset high income from other sources. This | | | | extent practicable, all factors should be pursued |
| offsetting strategy results in lower taxable income | | | | with the intention of strengthening your position in |
| and tax rates or brackets. The classic example is | | | | the event of a loss from self-employment or an |
| that of the highly compensated business | | | | IRS audit. Taxpayers should not be dissuaded |
| executive. He wants a second home/ranch in the | | | | from deducting their legitimate, ordinary and |
| country, but would like to (inappropriately) deduct | | | | necessary trade or business losses, simply out of |
| all or a portion of this second home in the form | | | | fear of an IRS audit.Feel free to publish or |
| of interest, depreciation, stables, horses, utilities, | | | | reproduce anywhere, as long as you provide a |
| maintenance, etc. The objective is to reduce the | | | | copy to and/or notify the author .A.J. Cataldo II, |
| after-tax cost of this second residence. | | | | Ph.D. |