The Hobby Loss Rules: Planning for Unprofitable Businesses

American culture still has a hint of the protestant work ethic. There are people in the United States who still work hard and are willing to take risks to make things happen. The country benefits if they are successful–particularly if it ends up in a viable commercial venture.

Not all ventures end up being successful. Congress has made a decision to not fund these ventures by way of providing an offset to other income. This limitation is found in Section 183, which are often referred to as the hobby loss rules.

The hobby loss rules take away tax deductions that would otherwise be available. They are a form of punishment for following a purpose and vision that is most likely not going to result in a successful commercial venture. This is even true for side gigs or moonlighting work. 

The IRS frequently challenges tax deductions for these ventures if the activity does not produce a profit.  The recent Jones v. Commissioner, T.C. Summary Opinion 2007-21, court case provides an opportunity to consider these rules.

Facts & Procedural History

Jones was employed full-time at an airport. In mid-2002, he attended a motorcycle riding course and he 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).

The IRS audited Jones’ tax return and disallowed the $8,000 of expenses. The case ended up in the U.S. Tax Court.

The Hobby Loss Rules

While Congress provided a broad deduction for business expenses, there are several limitations that disallow certain business expenses.  The hobby loss rules are one such limitation.

The hobby loss rules disallow deductions for expenses attributable to an activity “not engaged in for profit” except to the extent of gross income generated by the activity.  The phrase “not engaged in for profit” means any activity engaged in that does not have the primary objective of making a profit.

The regulations include a list of non-exclusive factors to determine whether an activity is not engaged in for a profit:

1. The manner in which the taxpayer carries on the activity;
2. The expertise of the taxpayer or his advisers;
3. The time and effort expended by the taxpayer in carrying on the activity;
4. The expectation that assets used in the activity may appreciate in value;
5. The success of the taxpayer in carrying on similar or dissimilar activities;
6. The history of income or losses with respect to the activity;
7. The amount of occasional profit, if any;
8. The financial status of the taxpayer; and
9. Any elements of personal pleasure or recreation.

No one factor is determinative, but the IRS and courts often look at the last factor. If the activity is enjoyable, the IRS will likely assert that it is a hobby.

It should also be noted that there is an exception to the hobby loss limitation that does not apply in this case.  This exception applies if the business made a profit for three of the past five consecutive years.

Balancing the Hobby Loss Factors

This brings us back to the Jones case.  The court considered the hobby loss factors, noting that Jones:

1. Was not able to produce records establishing that two clients paid him approximately $400. Did not prepare a business plan (with financial projections).
2. Did not keep a separate bank account for the business.
3. Employed a suspected tax shelter promoter (Daniel Gleason of “My Tax Man, Inc.”) to prepare his tax returns.

Given these facts, the court concluded that Jones’ deductions were limited by the hobby loss rules.

The Takeaway

Businesses that expect to incur a loss should proactively plan for the hobby loss rules.  This is particularly important for businesses that 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.

This may include timing the receipt of income or deductions to satisfy the three of five-year exception.

If this is not possible, it may include operating the business in a business-like manner.  This also needs to include documenting the business operations.  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.