Business or Hobby: Which is It?

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Business or Hobby

That is the Question

IRC §162 & 183

Presented by Andrew G. Poulos, EA, ABA, ATP

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Lesson Overview

• TIGTA Report and Audit Findings• IRC 162 & 183• 9 Factors to consider• Court cases • Election to postpone §183 determination• Filing Form 5213• Revenue Rulings• Interview Questions• Case Study

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TIGTA Report

• 9/27/07 – “Significant Challenges Exist in Determining Whether Taxpayers with Schedule C Losses are Engaged in Tax Abuse”

• Review looked at high income SB/SE taxpayers

• Total income of $100,000 or more

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TIGTA Report Continues

• Losses reported on Schedule C of Form 1040

• Activities considered to be NOT for profit

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TIGTA Audit Results

• Hobby expenses limited to hobby income

• 1.5M with significant other income filed Schedule C, only losses for 2002-2005

• 73% prepared by tax professionals

• 2.8B in taxes avoided in 2005

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Notes in TIGTA Report

• Only Schedule C losses included

• 4 years of consecutive losses

• Total income sources of $100,000 or greater

• No Schedule F, only Form 1040

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Changes Are Needed

“To prevent taxpayers from continually deducting losses in potentially not-for-profit activities to reduce their tax liabilities.”

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Is Hobby a For-Profit Endeavor?

• FS-2008-23 – June 2008

• IRS reminds taxpayers with guidelines

• IRC Section 183 – Hobby Loss Rule

• In general: deductions allowed for ordinary and necessary business expenses

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IRC Sec. 162 Considerations

• Ordinary and necessary expenses – trade or business

• Ordinary – common and accepted in the trade or business of taxpayer

• Necessary – appropriate for the trade or business of taxpayer

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Is Activity Important?

• Qualifies as business – If carried on with actual and honest expectation of earning a profit

• Activity not for profit – Losses may not be used to offset other income

• Income – Related Expense = Loss

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Is it a Business Expense?

• Must meet requirements of:

a) Carrying on Trade or Business b) For Production of Income

• Failing to meet either, consider IRC Sec. 183

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For Consideration

• Relevant Factors

• Include all pertinent facts

• IRC 183 – Activities Not Engaged in For Profit – Hobby Loss

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We Must Understand

• Understand deductible business expenses

vs.

• Non-deductible hobby expenses

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Distinguishing Between

• Business Activity – IRC § 162 Expenses

• Non-business “for profit” – IRC § 212 Expenses

• Not engaged in for profit – IRC § 183 limitations on deductions

• Personal activity – Deductions disallowed by IRC § 262 except to extent not otherwise allowable

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Applicable Code Sections

• Sec. 162 - Trade or Business ExpensesDeduction for all ordinary and necessary expenses

• Sec. 212 – Expenses for production of Income – for individuals:

1) Production/collection of income,2) Management/conservation/maintenance of property held for production of income, and3) Connection with determination, collection, or refund of any tax

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Sec. 183 – Activities Not Engaged in for Profit

• Individual or S Corp – If NOT engaged in for Profit there is NO deduction

• Exceptions:– Deductions allowed without engagement for profit– Deduction equals to deductions allowed if FOR PROFIT,

if gross income exceeds deductions allowed without engagement for profit

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Presumption

• Profit in 3 out of 5 years

• Profit 2 out of 7 years - Horse Business

• Presumed Activity for Profit

• Unless IRS establishes to the contrary

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9 Factors To Consider

1. Manner taxpayer carries on activity

2. Expertise of taxpayer or advisors

3. Time and Effort

4. Expectation of Asset appreciation

5. Success with similar or dissimilar activities

6. History of income/loss

7. Occasional profits

8. Financial status

9. Elements of personal pleasure or recreation

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Factors to Determine if Activity Engaged In for Profit

• Do time and effort indicate intent for profit?

• Do you depend on income from activity?

• Are losses due to circumstances out of your control or due to start-up expenses?

• Have you changed operations to improve profitability?

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Additional Factors

• Is your knowledge adequate to make this a profitable activity?

• What about profit in the past with similar activities?

• Was there a profit in some years?

• Any anticipation of profit in future from asset appreciation?

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Practitioner Alert

• Activity is “presumed” for profit if:

• Profit in at least 3 of last 5 years

• Includes current year

• Profit in at least 2 of last 7 years if horses

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If Activity Not for Profit

• Losses not used to offset other income.

• Losses occur when expenses exceed income.

• Limit applies to:Individuals PartnershipsEstates TrustsS Corporations NOT C Corps

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Allowable Hobby DeductionsUnder IRC 183

• Activity NOT carried on for profit

• Allowable deductions cannot exceed income

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Deductions for Hobby Activities

• Schedule A, Form 1040

• Deduct in following order:1.Full deduction for home mortgage interest and taxes2.Deductions not resulting in basis adjustment, advertising,

insurance premiums and wages may be taken to extent gross income is more than deductions under 1

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Deductions for Hobby Activities

3. Deductions that reduce basis taken last

Depreciation and Amortization

Only to extent gross income is more than deductions taken in step 1 & 2

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History in a Snap Shot

• Revenue Act of 1943 as IRC § 270

• Intension – limit individuals with multiple sources of income to reduce overall tax liabilities

• IRC § 270 repealed by Tax Reform Act of 1969 for years after 12/31/69

• Replaced with IRC § 183

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IRS Code § 183

• Applies to Individuals, Partnerships, S Corps and Trusts and Estates

• Not C Corporations

• No IRC or Regulations defines – just guidance

• Historically a difficult issue

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Generally

IRC allows deduction of expenses:

1) In trade or business – IRC § 162

2) Production or collection of income, management, conservation or maintenance of property held for production of income – IRC § 212

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Honest Objective of Making a Profit

• Keanini v. Comr., 94 T.C. 41 (1990) citing• Golanty v. Comr., 72 T.C. 411, 425 (1979), aff’d without published

opinion, 647 F. 2d 170 (9th Cir. 1981)

• Dreicer v. Comr., 78 T. C. 642 (1982), aff’d without opinion, 702 F. 2d 1205 (D.C. Cir. 1983)

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Taxpayers Bear Burden of Proof

• Hendricks v. Comr. - 1994

• Comr. v. Groetzinger – 1987

• Bot v. Comr. – 2003

• Am. Acad. Of Family Physicians v. U.S. - 1996

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Taxpayer MUST

• Devote time to business

• Honest belief profitable in the future

• Show what projected profit is to be

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NOT Engaged In for Profit

• § 183(b) allows:

– Deductions allowable without regard to activity for profit

– Deductions for amounts allowable if engaged in for profit, to extent of gross income remaining

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Treas. Regs § 1.183-1(e)

Gross Income:

All income, including sales, exchanges or dispositions and all other gross receipts

Reduced by COGS

Personal or nondeductible items will be excluded by IRS Examiner.

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Other Tax Return Items Affected

• SE tax

• Deduction for Health Insurance Premiums

• AMT

• Itemized Deductions

• AGI

• Personal exemption phase out

• Roth IRA Contributions

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CAUTION

AGI affects many items:Rental lossesMedical expenseCasualty lossesMiscellaneous deductionsAdoption expense creditInterest on education loans

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AMT Alert

Problem with Code § 183

Many not-for-profit expenses are reported on Schedule A – Miscellaneous

Not deductible for AMT purposes

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Treas. Reg. § 1.183-2(b)

• 9 Factors cited in Reg. – non-exclusive

1. Manner in which conducted2. Expertise of taxpayer or advisor(s)3. Time and effort expended4. Expectation assets may appreciate in value

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Reg. Continued

5. Success of taxpayer in similar or dissimilar activities6. Taxpayer’s history of income or loss with respect to activity7. Amount of occasional profits, if any8. Financial status of taxpayer, and9. Elements of personal pleasure or recreation

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How Many Factors Needed?

• No single factor controls

• Number does not control

• More weight given to objective facts than to taxpayer’s statement of intent

• Dreicer v. Comr. - 1982

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Profit in Early Years

• No blank check for future losses

• Profit objective in early years no guarantee not treated as not-for-profit in later years

• Daugherty v. Comr. - 1983

• Dennis v. Comr. - 1984

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Presumption Under § 183(d)

Safe Harbor:Engaged in activity for profit 3 out of 5 years2 out of 7 for horse activity

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Code § 183(e) - Election

Taxpayer is allowed to postpone determination of § 183(d) presumption.

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Code § 162

• Allows deductions for “trade or business” ordinary and necessary expenses

• Bona fide business must exist

• Expenses appropriate to carrying on “trade or business” and not capital expenditure. Not with respect to residence – exception IRC § 280A

• Welch v. Helvering - 1933

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Multiple Activities

• Treas. Regs. § 1.183-1(d)

• 2 or more separate activities not aggregated for not-for-profit determination

• Unless sufficiently interconnected

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Are Activities Interconnected?

• Based upon all facts and circumstances

– Degree of organizational and economic interrelationship,– Business purpose for various activity, and– Similarity of various undertakings.

Commissioner generally accepts taxpayers justification of interconnected activities UNLESS cannot be supported and each activity treated separately.

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Taxpayer’s Subject to § 183

• Individuals – IRC § 183(a)

• S corporations – IRC § 183(a) – Treas. Regs. § 1.183-1(f)

• Partnerships – reflected in partnership’s distributive shares – IRC § 703(a)

• Trusts and Estates – IRC § 641(b)

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C Corporations

The provisions of IRC § 183 do not apply to C corporations.

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Election to Postpone Determination

• IRC § 183(e)

• Election to postpone determination of presumption until close of 4th taxable year or 6th taxable for horse activities

• Following 1st taxable year engaged in activity.

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If Election Made

• Taxpayer may file returns in the interim on assumption activity is for profit

• Activity generating losses – not carried on for full profit presumption period, taxpayer may elect to postpone determination

• After filing of required returns – case file returned to IRS examiner for determination

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Making the Election

• Form 5213, Election to Postpone Determination as To Whether the Presumption Applies That an Activity is Engaged in for Profit

• Used when taxpayers wish to postpone determination

• Election made by Partnership or S Corporation is binding upon all persons

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When to File

• Within 3 years after the due date of the return - No extensions

• For 1st year of the activity

• Not later than 60 days after notice from IRS proposing to disallow deductions of activity

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Practitioner Note

Form 5213 is rarely used by taxpayers until IRS proposes to disallow the activity as not engaged in for profit.

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Placing in Suspense

• Election made

• IRS will generally close case to suspense until end of presumption period

• Upon filing of all returns for periods, case returned to IRS Examiner for determination

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If Taxpayer Wishes to File an§ 183(e) Election

The IRS Examiner should:

1. Secure fully completed and properly signed Form 5213

2. Advise taxpayer of suspense process and to retain all pertinent books and records for each of the presumptive years

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Form 5213

• Election to Postpone Determination

1. Who Should File

2. When to File

3. Automatic Extension of Period of Limitations

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What About the Statute of Limitations ?

• Filing of Form 5213 automatically extends statute for any deficiency attributable to the activity

• Example: Activity subject to a 5 year presumption period beginning in 2004 and ending 2008, the period of limitations automatically extends to April 15, 2012 for all tax years in presumption period.

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Supporting Law Revenue Rulings

• Rev. Rul. 55-258 – Not engaged in for profit – taxable but not for SE purposes

• Rev. Rul. 75-14 – FRV required to relative, deduction only for expenses if itemizing

• Rev. Rul. 77-320 – Partnership, reflected in distributive share

• Rev. Rul. 2004-32 – OIH cannot be created to convert nondeductible personal living expenses

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Supporting Law Case Law

• Numerous § 183 Court Cases

• Some opinions favor taxpayers

• Others support the Government’s position

• Cases supportive of the taxpayer’s position should be used to defend taxpayer’s position

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Suggested Interview Questions for Each of 9 Relevant Factors

Practitioners should use to determine if activity is or is not for profit:

Background and general description of the business.

How are the business records maintained?

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More Interview Questions

What efforts are made in terms of attracting customers and securing suppliers or products necessary for the business?

When is a profit expected?

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Expertise of the Taxpayer/Advisors

• Background information about type of activity prior to start up

• Taxpayer’s relevant education

• Reliance on others in starting or developing business

• Research or extensive study regarding business

• Other life experience to prepare

• Related organizations and how long

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Time and Effort Expended

• May be given more weight if no personal or recreation aspects

• Is this a full or part=time activity?

• Who is involved with the daily operations?

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Expectation Assets will Appreciate

• Profit encompasses appreciation

• List assets used in the activity

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Success of Taxpayer

• If taxpayer has engaged in similar activities in the past, converting unprofitable to profitable, may indicate engaged in for profit

• What other activities has the taxpayer had previous success?

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Taxpayer’s History of Income/Loss

• Losses sustained beyond period customarily thought to bring to profit, unless not due to control of taxpayer may indicate not engaged in for profit

• Series of net income years would be strong evidence activity engaged in for profit

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Occasional Profits

• Large losses and only small profits = activity not engaged in for profit

• Opportunity for substantial profit on highly speculative venture = activity engaged in for profit

• What profits have been earned in any year?

• What amount of an investment has the taxpayer made in the business?

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Financial Status of Taxpayer

• No substantial income or capital from other sources = engaged in for profit

• Personal or recreational elements = engaged in not for profit

• Does taxpayer have substantial income or capital from other sources?

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Elements of Personal Pleasure

• An activity will not be treated as not engaged in for profit merely because the taxpayer has purposes other than solely to make a profit

• Deriving personal pleasure from the activity is insufficient to determine activity not engaged in for profit

• Was taxpayer involved or interest in this activity prior to establishing it as a business?

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Arlene – Case Study

• Sales of artwork in 2008

• 10 years before and years after 2008

• Gallery showings and efforts of Mary, a professional art consultant recommendations

• Impressive witnesses, knowledgeable about art can testify about Arlene’s abilities, reputation and potential

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1998 through 2007 (Schedule C)

Year Expenses Gross Inc. Losses1998 $16,093 $ 7,586 $ 8,5071999 6,363 1,280 5,083 2000 15,328 8,790 6,5382001 16,565 8,192 8,3732002 19,328 11,042 8,2862003 23,218 4,363 18,8552004 21,828 400 21,4282005 26,113 1,325 24,7882006 34,135 18,299 15,8362007 46,995 5,975 41,0202008 82,900 7,700 75,200

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And, in 2008

Arlene reported an additional loss of $75,200

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More Facts About Arlene

• Keeps checks and receipts for expenditures in labeled envelopes

• Relies on Gordon Goodman, EA to review and determine which expenses were business and to prepare income tax returns

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Arlene’s Living Arrangements

• Martha’s Vineyard in warmer months

• New York City rest of year – traveling between and elsewhere at various times

• Rents small studio/apartment and two separate rooms in NYC hotel

• Rooms not connect to apartment

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Office In Home

• Uses portion of studio/apartment as living area and rest as studio/work area

• Two other rooms as storage space for art

• Does not shop or socialize, spending most of her time working on creating art, producing and promoting it

• Apartment is filled with her art

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More About Arlene

• Due to toxic plastic resin needs to work in well-ventilated space

• Rents loft in NYC for toxic material use as well as to store art work

• She also rented another loft to store her paintings

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Cost

Rent at hotel $ 400.00Rent – 2 other rooms $ 550.00Annual cost $ 11,400Disputed cost $ 6,339EA took 50% as business $ 1,092Plus rent for 2 other rooms $ 4,754Loft rent $ 6,175Warehouse storage $ 819No rent for Martha’s Vineyard

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Other Expenses

• Insurance on artwork $ 1,000• Liability insurance on apartment $ 30

• Purchase of Volvo station wagon for $18,750 on 6/11/08 – used in business

• Previously used older car for same business purposes – delivery, supplies, etc

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More Expenses

• Insurance and parking space in NYC garage

• Older car moved to Martha’s Vineyard

• Volvo in NYC

• Insurance carried on both cars

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Arlene’s Deductions

• Parking $ 1,214• Automobile expenses $ 1,257• Insurance on both cars $ 3,470• Depreciation $ 4,688

• No tentative investment credit of $750 on Volvo taken

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Analysis of Depreciation

• $627 for a $4,181 Computer

• $112 for upholstery on furniture in NYC apartment

• $46 for a $307 humidifier

• $15 for telephone

– All acquired in 1984

• $427 in tentative investment credit, but did not use

• $5 for typewriter and $23 for unidentified item, acquired before 2008

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There was More

• Contract labor paid $2,304• Materials $5,970

• Professional services $8,169Mr. Goodman, EA – 8 years

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And Finally

• Entertainment - $1,629• Studio expense - $450• Travel - $3,334, Egypt

$2,000, other $1,334 including ferry trips & travel to Martha’s Vineyard

• Telephone - $1,372

• $10 per month allocated of telephone for personal use, deducting $1,252, including all long-distance.

• Advertising - $74• Dues and publications - $176• Freight - $12

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Let Us Not Forget

• Interest - $50

• Office expense - $98

• Repairs - $125

• Xmas and gifts - $189

• Publicity Photos - $1,023

• Credit card fee - $20

• Taxis - $305

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IRS Determination

• 2006, 2007 and 2008 – Activities not engaged in for profit

• Disallowed all Schedule C deductions to extent they exceeded her gross receipts

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IRS Findings

• Receiving director’s fees and dividends, no longer dependent on artistic activities

• Long history of losses

• Great personal pleasure derived from creating artwork and seeing it displayed

• Income from other sources enabled her to pursue art career

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Conclusion• Arlene is sculptor and painter

• Worked full time as an artist for many years

• Engaged in artistic endeavors all adult life

• From 1959, when divorced from husband, through 1974, supported herself entirely with income from artistic endeavors

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Arlene

• Sold art work and taught classes for family owned company

• After death of mother became BOD member, earning Director fees in 1975

• She received $63,000 in cash plus stock

• In 1984, received $559,875 in partial liquidation of her stock, continuing to receive dividends

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Arlene Then …

• Was not dependent upon the sale of her art work for her livelihood

• Obtained a number of fellowships at artists’ colonies

• From the early 1970s through the early 1980s she was awarded 13 fellowships and 2 awards in recognition of her potential as an artist

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Art Displayed

• 1973-1984 work was in numerous exhibitions at museums and art galleries

• Displayed where art sold for a profit

• Gallery showings in the 1970’s, 1978 and 1984

• Shown in galleries and museums, after the year in issue

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Arlene’s Art Work

• Exhibited with very financially successful artists

• Required she contact galleries and museums to have work accepted for exhibition

• Word of mouth, showings and exhibitions, reviews by art critics and advertising efforts, reputation spread

• Museums sent invitations to view and Arlene held private showings at her apartment in NYC

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Art Activities for Profit

• Section 183 allows deductions

• Ordinary and necessary if not engaged in for profit to extent of gross income, less amount allowable regardless of whether activity not engaged in for profit

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Considerations

• Arlene has shown pursuit of artistic activities with objective of making a profit

• Test is “actual and honest objective of making a profit”

• Expectation might not have been reasonable but objective to make a profit

• All considerations made

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Factors Pointing to Profit Objective

• Improving skills• Time devoted• Fellowships for artists• Did not require lavish

lifestyle• Promotion of work by

herself• Promotion of work by

others

• Consistently sold art• Personal pleasure not

sufficient • History of losses less

persuasive in art field than others

• Record is replete with evidence of showings and exhibitions of work as result of her efforts to promote

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While Not Selling as Much as Hoped

• Arlene sought recognition and profit, maintaining large inventory

• Arlene will enjoy greater financial benefits, having much success and recognition and who wants to sell and intends to make a profit

• Unlike Porter v. Commissioner – 1969-288, the taxpayer did not sell much art and only for small amounts over a 10-year period

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Further Considerations

• Arlene, a lifelong artist• Sold much more art for significant amounts• Is nationally recognized with work shown and exhibited in well-

known galleries

• Impressive listing of witnesses• At any time, Arlene might become more commercially successful

and earn enough to cover losses

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Final Conclusion

• I conclude that she engaged in the activity with “the actual and honest objective of making a profit”.

• Based on Stella Waitzkin v. Commissioner, T.C. Memo, 1992-216

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