Deduct What You Love, With Hobby Losses
A hobby is a regular activity done for enjoyment at leisure. STA is often asked; “Can I deduct my hobby losses?” When an activity is not pursued for profit, limited “hobby loss” deductions are allowable under section 183(b) of the Internal Revenue Code.[1] When calculating deductions, losses incurred from your personal hobbies should not be deductible. Ann and Mitt Romney attempted to improperly classify their Olympic dressage competitor, Rafalca, as a business expense in 2010. The Romney’s reported losses from Rob Rom Enterprises, which owned Rafalca. Ann Romney was an officer of Rob Rom Enterprises, but she did not participate enough in running the business to be considered an actively managing member of the company. Her two business partners, Amy Roberts Ebeling and Beth Myers directed the day-to-day operations of Rob Rom Enterprises, which trained show horses and operated commercial riding stables (where clients like the Romney’s kept their horses). Additionally, the Romneys loaned between $250,000 and $500,000 to Jan Ebeling’s Stable.[2] Jan trained and rode Rafalca. Because Ann Romney did not materially participate in the management or operations of Rob Rom Enterprises, she was a passive investor. Thus, the IRS classified her Rafalca-related payments as passive losses.[3] This meant that the loans to Ebeling’s stable and Ann’s Rafalca-related payments were not deductible business expenses. Of the $77,731 horse-related costs incurred, the passive loss rules permitted the Romneys to only deduct $49.[4]
Compare the situation of the Romney’s to the artist Susan Crile. In Crile v. Commissioner, Susan Crile earned between $80,000 and $100,000, annually from teaching.[5] Additionally, Susan worked for over 40 years in media and completed over 2,000 works of art. Between 2004 and 2009, she reported net losses of $50,000 from her creative activities.[6] The IRS then challenged Susan’s deductions, arguing that her activity as an artist was a hobby because her occupation was teaching. Fortunately, Susan kept meticulous records; she included the sale price and identity of her buyers, she hired bookkeepers, she tracked her inventory, and she compiled financial records. These detailed records demonstrated her profit-seeking intention. As such, Susan prevailed over the IRS and was allowed to claim her $50,000 losses.
The distinction between hobbies and business activities depends on whether the activity is engaged for profit. If you intend to realize a positive return from the time and resources you spend on the activity, then you are engaged in the activity for profit. The IRS does not require a reasonable expectation of profit to qualify as a trade or business.[7] The facts and circumstances must indicate that you entered into the activity to make a profit.[8] Otherwise, you are engaging in a hobby.
For example, in Weller v. Commissioner, the Tax Court noted that “[A] business would not be turned into a hobby merely because the owner finds it pleasurable; suffering has never been a prerequisite to deductibility.”[9] The Internal Revenue Code does not require the purpose to be predominately for profit; it merely requires that the activity is “engaged in for profit.” Section 183(d) creates a rebuttable presumption that the action was engaged in for profit, concerning a given year, if the operation was profitable (that is, if gross income exceeded deductions) for three years out of five years ending with the year in question.[10]
Traditionally, most hobbies involve “side-gigs” focusing on a high pleasure-to-effort ratio. Horse racers become horse breeders, who then bottle and sell their horses “liquid talent.” Consistently, the IRS continues to foil these taxpayers attempts to deduct such “separate ventures” as business expenses.[11] For tax purposes, separate activities may be regarded as a single activity if they are reasonably related and the income from the activities exceeds the deductions claimed. For example, if you own land and farm on the same property, then the IRS considers holding the real estate and farming to be a single activity. No amount of Derby-ready breeding can substantiate your deductions if you fail to exercise proper corporate formalities and tax compliance.
Not only for the living, but the taxable income of an estate or trust is also subject to the hobby loss rules. Accordingly, where an estate or trust is engaged in an activity which is not for profit, the rules of section 183 apply in computing the allowable deduction of a trust or estate. Should Rafalca outlive the Romneys, the IRS will likely continue to limit any horse-related deductions claimed by the Romney’s estate.
Taxpayers bear the burden of proving whether you have a hobby or a business. This test applies to individuals, S corporations, estates, trusts, and partnerships. There is no settled case law establishing whether C corporations or limited liability companies can engage in a hobby.[12] The IRS maintains that deductions attributable to a not-engaged-in-for-profit activity should always be allowable to the extent of the income from the activity. STA will help you navigate the maze of hobby loss deductions and make both your business and hobbies work for you.
[1] Hobby Loss. (1964) A nondeductible loss arising from a personal hobby, as contrasted with an activity engaged in for profit. The Law generally presumes that an activity engaged is engaged in for profit if profits are earned during the last three of the last five years.
[2]http://www.taxhistory.org/www/features.nsf/Articles/6D4819B8FAEF9ABA85257A4D007FB804?OpenDocument
[3]To combat tax sheltering of ordinary earned income, IRS § 469 isolates passive activities from the taxpayer’s other income. Passive activities are rental or business enterprises in which the taxpayer is not involved with the operations on a standard, continual, and significant basis. There is a special section 183(d) hobby loss rule for horses; which covers racing stables, training, and showing horses. This is a rebuttable presumption, and the IRS may challenge the deduction.
[4] https://www.forbes.com/sites/janetnovack/2012/07/19/both-left-and-right-got-the-taxes-on-the-romneys-olympic-horse-wrong/#616ddc8d1c0a
[5] Crile v. C.I.R., 108 T.C.M. (CCH) 372 (Tax 2014).
[6] https://www.forbes.com/sites/anthonynitti/2018/12/09/the-top-tax-court-cases-of-2018-reunited-with-the-hobby-loss-rules-and-it-feels-so-good/#3939832b24cb.
[7] The IRS has identified nine circumstances used to analyze whether an activity was entered into for profit. Reg. § 1.183-2.
[8] In Antonides v. Commissioner, the energy crisis of the 1980’s made the costs of fuel and fiberglass so high, that there was no reasonable expectation of profit from chartering yachts at this time. Thus, the court determined that the taxpayer was not motivated by profit when he acquired a yacht. Antonides v. C.I.R., 91 T.C. 686, 695 (Tax 1988), aff’d, 893 F.2d 656 (4th Cir. 1990).
[9] Weller v. C.I.R., 102 T.C.M. (CCH) 260 (Tax 2011) (quoting Jackson v. Commr. of Internal Revenue, 59 T.C. 312, 312 (Tax 1972)).
[10] Reg. § 1.183-1
[11] In Akey v. Commissioner, the Tax Court decided that Terry Gene Akey, did not have a profit seeking motive for acquiring sports memorabilia. Thus, he could not deduct the cost for insuring sports memorabilia as a business expense. https://www.ustaxcourt.gov/ustcinop/opinionviewer.aspx?ID=10623
[12] Tres. Reg. § 1.183-1(a).