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Checkpoint Contents Federal Library Federal Editorial Materials PPC's Federal Tax Compliance Library 1040 Deskbook Business, Farm, and Rental Chapter 8: Sole Proprietorships (Schedule C) Key Issue 8A: Distinguishing an Active Trade or Business from a Hobby.

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Key Issue 8A: Distinguishing an Active Trade or Business from a Hobby.

Determining if an individual is engaged in carrying on a trade or business has implications beyond whether a net loss will be allowed to offset other income, although this income offset is the most obvious benefit for many taxpayers. Items affected by this determination include (but are not limited to): 1. Self-employment (SE) tax and, ultimately, social security benefits. 2. IRA, Keogh, SEP, or SIMPLE retirement plan contributions. 3. Deductions for health insurance premiums and contributions to medical savings accounts (MSAs). 4. Home office deductions. 5. Limited expensing (Section 179) deductions. 6. Amortization of start-up expenditures. (See Key Issue 8D.) 7. Character of gain or loss upon disposition of assets (i.e., Section 1231). 8. Net operating loss (NOL) carryovers and carrybacks. 9. AGI-sensitive deductions including rental losses, medical expenses, casualty losses, etc. 10. AGI-sensitive credits. (See Chapter 35.) 11. Deferral of estate tax and the special-use valuation of assets. Therefore, it is no surprise that this issue has historically been one of the most frequently litigated and controversial areas of individual income tax law.

Distinguishing between a Hobby and an Active Trade or Business

The Internal Revenue Code backs into the rules governing activities not engaged in for profit (commonly referred to as hobbies) by including all activities of the taxpayer other than those for which deductions are allowable under IRC Sec. 162 (expenses of carrying on a trade or business) or 212 (expenses incurred for the production or collection of income or for the management, conservation, or maintenance of property held for the production of income) [IRC Sec. 183(c)]. Determining if an activity is engaged in for profit is based on the facts and circumstances of each case. However, Reg. 1.183-2(b) provides factors to consider. These factors are frequently applied in relevant case law. (See Checklist C104.) Although certain activities are more susceptible to the hobby loss taint (e.g., weekend farmer/rancher; auto racing; certain pyramid marketing schemes; and horse or dog racing, breeding, or showing), no activities are immune. For example, in Ranciato, the Tax Court held that a retail pet store failed to qualify as a for-profit activity based on an analysis of the factors outlined in Reg. 1.183-2(b). But see Rinehart for an example of a horse breeding activity that was held by the Tax Court to be a for-profit venture and Morrissey for an example where auto racing was held to be a for-profit venture. The presence of a profit intent in earlier years is not determinative for the tax year in question. In any case, the taxpayer must be conducting the activity with the actual and honest intent to make a profit in order to escape the hobby loss taint (Fairbanks; Filios). While maintaining financial records can be an indication of a taxpayers

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profit motive (Tamms), the existence of financial records alone may not be enough to demonstrate that an activity is not a hobby (Stasewich). Obtaining professional advice about how to make the activity profitable is another indicator of a profit motive, but failure to follow the advice can demonstrate the lack of such a motive (OConnor). Mitchell and Keating have detailed discussions of the factors outlined in Reg. 1.183-2(b). IRS Fact Sheet (FS-2008-23), Is Your Hobby a For-Profit Endeavor? also gives general discussion and guidelines for this topic. The Audit Techniques Guide (ATG) located at http://www.irs.gov/businesses/small/article/0,,id=208400,00.html provides a detailed look at issues the IRS considers when auditing for hobby activities.

Reporting Hobby Income and Expenses When Activity Is Not Deemed to Be a Trade or Business

Observation: Hobby income cannot be ignored because IRC Sec. 61(a) provides that gross income includes income from whatever source derived unless there is a specific exclusion. There is no exclusion for hobby income. Hobby income is reported on page 1, line 21, of Form 1040. It is not subject to SE tax because a hobby is not considered a trade or business (Rev. Rul. 55-258). Thus, practitioners should inquire as to whether a client has hobby income and, if so, also get information about related deductions. Depending on the amounts involved, practitioners should consider whether there is basis to treat the activity as a trade or business or whether, with proper planning (for example, a formal written business plan), the activity could become a trade or business in the future. Planning Tip: Where tax practitioners encounter two closely related activities that arguably represent a single business and one has a hobby risk, reporting on a single tax form (e.g., one Schedule C) should be considered. The Tax Court allowed a tobacco farmer in Kentucky who opened a display garden business to aggregate the farming and garden business activities as one for purposes of testing the hobby loss rules. The court determined that there was a close organizational and economic relationship between the farm and the display garden business, that both activities were conducted at the same location, and that both were attempts to make the farm profitable (Tobin). Similarly, a horse barn interior designer was allowed to combine her equestrian activities with her design activities, since the equestrian activities were used to locate potential clients (Topping). Conversely, the Tax Court rejected combining an apple farming activity with a dental practice despite the health aspect of each (Zdun). Also, farming activities were not combined with the investment in the land on which the farming was conducted when the taxpayers primary intent was to profit from land appreciation rather than the farming activities (Burrus). For an activity deemed to be a hobby, expenses are allowed to the extent of income produced by the activity, subject to the following ordering system [Reg. 1.183-1(b)]: 1. Expenses incurred that are otherwise deductible without regard to the profit motive (e.g., real estate taxes). 2. Expenses incurred that would be deductible if the activity was engaged in for profit, but which do not result in a basis adjustment. These include normal trade or business expenses (such as advertising, insurance, and utilities) other than depreciation or amortization. 3. Expenses meeting the requirements in category 2, which do result in a basis adjustment (e.g., depreciation expenses). Expenses in category 2 or 3 are allowed only to the extent of the excess, if any, of income from the activity over allowable expenses from category 1. (See Example 8A-1.) Certain types of expenses may fall in more than one category. Expenses that fall in category 2 or 3 are deductible only as miscellaneous itemized deductions and then only to the extent of any remaining hobby income. Since these deductions are subject to the 2% of AGI limitation, a taxpayer may end up with net taxable income from a hobby activity even though the allowable expenses equal the income from the activity. Note: Because hobby expenses are deductible only as Schedule A miscellaneous itemized deductions, taxpayers who do not itemize deductions cannot claim any deductions attributable to a hobby activity. Also, a taxpayer with significant hobby expenses may become subject to alternative minimum tax (AMT) because miscellaneous itemized deductions are not deductible for AMT (Purdey). (See Chapter 31 for additional discussion of

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AMT.) Example 8A-1: Hobby loss limitations.

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In the current year, Bobby Canine begins breeding and selling Labrador retrievers and derives $2,200 of income from the activity. He does not expect to report a profit for three out of five years (see safe harbor rule later in this key issue) nor can he support that the activity is for-profit based on the facts and circumstances. Thus, the activity is deemed to be a hobby. Bobbys AGI (before the dog breeding activity) for the current year is $130,000, and he has $1,850 of other miscellaneous itemized deductions subject to the 2% of AGI floor. His hobby expenses (food, veterinarian bills, etc.) total $2,300. These are deductible only to the extent of hobby income ($2,200) and only to the extent that, when aggregated with other miscellaneous itemized deductions, they exceed 2% of AGI. The net amount of miscellaneous itemized deductions is calculated as follows:
Miscellaneous itemized deductions from hobby (limited to hobby income) Other miscellaneous itemized deductions Total miscellaneous itemized deductions 2% of AGI [2% $132,200 ($130,000 plus $2,200 hobby income)] Net miscellaneous itemized deductions allowed $ 2,200 1,850 4,050 (2,644) $ 1,406

Thus, Bobby is allowed miscellaneous itemized deductions, after applying the 2% floor, of $1,406. Instead of reducing hobby income to zero, the limitation on deductible miscellaneous deductions has caused Bobby to have net taxable income from his hobby of $794 ($2,200 of income reportable on the other income line on page 1 of Form 1040 less $1,406 of hobby expenses deductible on Schedule A as miscellaneous itemized deductions). The 2% of AGI floor has penalized Bobby because his hobby expenses were not, in fact, deductible to the extent of hobby income. There is no provision for the carryover of disallowed hobby expenses. Bobby did not receive any deduction for depreciation on his kennel because all hobby income was offset with other types of expenses. Therefore, no reduction to the adjusted basis of his kennel is required [Reg. 1.183-1(b)(2)(ii)]. Variation: Assume that Bobby had $2,850 in other miscellaneous itemized deductions, rather than $1,850. The net amount of miscellaneous itemized deductions is calculated as follows:
Miscellaneous itemized deductions from hobby (limited to hobby income) Other miscellaneous itemized deductions Total miscellaneous itemized deductions 2% of AGI [2% $132,200 ($130,000 plus $2,200 hobby income)] Net miscellaneous itemized deductions allowed $ 2,200 2,850 5,050 (2,644) $ 2,406

In this case, Bobbys increase in taxable income due to the hobby loss is only $44 (the increased AGI limitation of 2% $2,200) since he was already able to use a portion of his miscellaneous itemized deductions. Practice Tip: The practitioner should attempt to locate as many other miscellaneous itemized deductions as possible when the taxpayer has hobby income in order that the hobby deductions may better offset the hobby income. Practice Aid O503 has a list of common miscellaneous itemized deductions. Caution: Since miscellaneous itemized deductions are an AMT preference item, the kennel expenses could effectively be disallowed if

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Bobby is subject to AMT. Therefore, all of the income from the kennel would be included as other income on page 1 of Form 1040 without any corresponding deductions. For further guidance on AMT preference items, see Chapter 31. The expenses could also be effectively disallowed if the taxpayer did not have enough other itemized deductions to file Schedule A.

Safe Harbor Rule Helps Eliminate Uncertainty between a Hobby and an Active Trade or Business
A statutory safe harbor is provided that, if met, causes a presumption that an activity is a for-profit endeavor. If the safe harbor is not met, the taxpayer must establish a profit motive using the subjective factors mentioned in the regulations. (See Checklist C104.) To meet the safe harbor, an activity must generate a profit in at least three of the five years (two of seven years for activities involving horse racing, breeding, training, or showing) ending with the tax year in question. If the safe harbor is met, the burden of proof for lack of profit motive is shifted to the IRS. The IRS can still rebut the profit motive presumption by proving that the activity is not engaged in for profit (e.g., by showing that the profitable years generated immaterial profits while the unprofitable years generated large losses) [IRC Sec. 183(d)]. Applying the Safe Harbor Rule. The safe harbor rule applies only for the third (or second) profitable year and all subsequent years within a five-year (or seven-year) safe harbor period that begins with the first profitable year [Reg. 1.183-1(c)]. Example 8A-2: Applying the safe harbor rule. Tim Jones begins a new activity in Year 1 and incurs losses from that activity in Years 1 and 3. The activity is profitable in Years 2, 4, 5, and 6. Assuming the five-year test applies to the activity, the five-year safe harbor period begins with Year 2 (because it is the first profitable year) and covers Years 26. The safe harbor rule applies only for Years 5 and 6 (because Year 5 is the third profitable year after the start of the five-year period) but does not apply for Years 14. Thus, the IRS can assert that the losses incurred in Years 1 and 3 must be reported under the hobby loss rules (unless Tim can prove otherwise under the subjective factors in the regulationssee Checklist C104). Furthermore, the IRS presumably can assert that profitable Years 2 and 4 must also be reported under the hobby loss rules. As previously explained in this key issue, such reporting may not result in a total offset of income with deductions because the hobby income is reported on page 1 of Form 1040 and the allowable hobby deductions are reported on Schedule A of Form 1040 as itemized deductions subject to the 2% of AGI limitation. Additionally, if there is AMT exposure the miscellaneous deductions may be disallowed. Because Tim cannot rely on the safe harbor rule before Year 5, he will have to rely on facts and circumstances to establish a profit motive for Years 14. Alternatively, Tim can make an election under IRC Sec. 183(e) to postpone the safe harbor determination (see discussion later in this key issue).

Observation: The safe harbor rule of IRC Sec. 183(d) is not as helpful for loss years as it may first appear. Because the safe harbor applies only after a taxpayer incurs a third profitable year within the five-year testing period, only loss years arising after that time (and within the five-year period) are protected. Therefore, for a new activity, losses incurred in the first several years will never be protected under the safe harbor rule, whether or not the activity turns a profit in later years. In summary, taxpayers should be cautious relying on the safe harbor rule since it may not cover the loss years incurred in the testing period. Its use may be more beneficial for taxpayers who are racing, breeding, training, or showing horses since there are fewer required profitable years (two years) and a longer testing period (seven years). Example 8A-3: Three profit years must precede safe harbor loss year. At the end of Year 3 in Example 8A-2, Tim could not rely on the safe harbor (presuming that Year 3 is a profit-motive year) and report income and deductions for Year 3 on his Schedule C. Even if he knew what the future outcome would be for Years 46, future years

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have no bearing on the ability to use the safe harbor for Year 3 under the general presumptive rule of IRC Sec. 183(d). (Also, three profitable years had not yet occurred at that time.) In fact, although two of the next three years did produce profits (thus producing an applicable safe harbor five-year period containing three profitable years), the application of the safe harbor does not apply to a loss year until Year 5. Electing to Postpone the Safe Harbor Profit Presumption. A taxpayer may elect to delay a determination as to whether the safe harbor applies until the close of the fourth (or sixth, in the case of horse racing, breeding, training, or showing) tax year after the tax year in which the taxpayer first engages in the activity [IRC Sec. 183(e)(1)]. To make a valid election, the taxpayer must file Form 5213 (Election To Postpone Determination as to Whether the Presumption Applies That an Activity is Engaged in for Profit). (See Election E1002.) The election Form 5213 is filed, separate from any other form or return, with the IRS Service Center where the taxpayer files his or her tax return. The election automatically extends the statute of limitations for all years in the postponement period until two years after the due date (without extensions) of the return for the last tax year in the five- (or seven-) year presumption period. However, the statute of limitations is extended only for items related to the activity and other items on the return that would be directly affected by the activitys deductions [IRC Sec. 183(e)(4)]. Practice Tip: While filing Form 5213 allows a taxpayer additional time to establish the existence of a trade or business activity, it also alerts the IRS to a possible hobby issue. Thus, as a practical matter, Form 5213 is rarely used until the taxpayer has been notified that the IRS proposes to disallow deductions related to an alleged hobby activity. If the taxpayer has been notified that the IRS proposes to disallow deductions, Form 5213 should be sent to the IRS office that sent the notification. Observation: The Tax Court has ruled that the Form 5213 not only extends the period for assessing deficiencies associated with an activity, but also applies to a taxpayers right to make a claim for overpayment. Accordingly, a taxpayer was allowed to claim refunds for additional deductions related to a horse boarding and training activity during the two years for which the statute was extended by filing Form 5213 (Wadlow).

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