Common Business Tax Problem: The Hobby Loss | Colorado Tax Attorney: Denver Tax Lawyer

It is important for self-employed taxpayers to think about some of the more typical business tax problems given the Jones v. Commissioner provides an example of one of these common business tax problems, namely, the hobby loss tax rules.

Jones was employed full-time at an airport. In mid-2002 Jones attended a motorcycle riding course and he then purchased a motorcycle. Jones claimed that he began operating a motorcycle riding course business on his 2002 tax return. Jones’ tax return showed income from this activity of about $400 and expenses of about $8,000 (most of which was depreciation, probably for his motorcycle).

Apparently Jones was not able to produce records establishing that two clients paid him approximately $400. In addition, Jones did not prepare a business plan (with financial projections), he did not keep a separate bank account for the business, and, perhaps most damming of all, Jones employed a suspected tax shelter promoter (Daniel Gleason of “My Tax Man, Inc.”) to prepare his tax returns.

This case provides a good example of what not to do in operating a business. Taxpayers are well advised to follow the formalities of a business to obtain the benefits of operating in a corporate capacity, regardless of the tax consequences. Specifically, taxpayers should prepare a business plan (with financial projections), form a separate legal entity, maintain a separate business checking account, document items of income and expense, and, most importantly, use a reputable tax advisor.

Business owners should also use extra caution if their business will produce a loss for one or more tax years and, especially, if the business operations have some fun or pleasure aspect (such activities often include sports cars, works of art, horses or other livestock, or, as in this case, a motorcycle).

While it is okay (from a tax perspective) for a business to generate a loss, taxpayers should prepare to defend their loss if the IRS opts to audit the taxpayer’s tax return. If this is a concern, a more conservative approach would be to only claim losses up to the amount of the business income for any one tax year. Had Jones taken this position, he probably would not have had to litigate this type of tax matter.