Hobby Loss Exposure (IRC §183)
Why does this matter?
IRC §183 says that activities not engaged in for-profit receive less beneficial tax treatment than a business with a profit motive.
The stakes are high, and even higher post-TCJA
If the IRS reassigns an activity from a profit motive activity to a no-profit motive activity, the financial consequences could be immense.
Losses from the activity will be non-deductible & do not carry forward
Expenses are not deductible from 2018-2025*
Tax will increase from lost deduction
Penalties and interest on the additional tax will be assessed
Example:
Profit Motive | No Profit Motive (2018-2025) | No Profit Motive (Pre-2018, Post-2025) | | ||
W2 Wages | $100,000 | | $100,000 | $100,000 | |
| | | | | |
Musician income | $5,000 | | $5,000 | $5,000 | |
Musician expenses | ($25,000) | | N/D | $25,000 | |
Musician net income | ($20,000) | | $5,000 | ($20,000) | |
N/D Loss | | | | $20,000 | |
| | | | | |
Taxable income | $80,000 | | $105,000 | $100,000 | |
Tax (25%) | $16,000 | | $26,250 | $25,000 | |
Who is at risk for hobby loss exposure?
Losses in 3 of the last 5 years.
IRC §183 (d) provides that if an activity shows a profit in 3 of the last 5 years then the activity has a profit motive and is not a hobby.
⚠ Common misconception: If you have losses in 3 out of 5 years, it does not mean you are a hobby, it just means you do not automatically qualify under the safe harbor to have a profit motive.
Some activities will get more hobby loss scrutiny than others.
According to IRS Audit Technique Guide (ATG):
A recent report identified the most likely culprits
The Treasury Inspector General for Tax Administration issued a report in 2016 that concluded that a large number of taxpayers may have circumvented hobby loss rules in order to deduct losses that have cost the US Government several billion dollars.
The report recommended identifying and auditing individual returns that improperly deduct hobby losses that can help reduce noncompliance.
The following returns were sampled to determine the amount of compliance of in the IRC §183 arena:
Schedule C loss of > $20,000
Schedule C revenue of <$20,000
Wages > $100,000
4 consecutive years of losses
The result was 88% of these returns did not comply with hobby loss rules. The IRS uses the research when determining if hobby loss rules should be examined.
How does IRS determine profit motive?
The IRS examines all facts and circumstances in order to determine profit motive; unfortunately, the taxpayer cannot merely state their intent to make a profit.
Some good news: IRS does not consider the likelihood, just the objective of making a profit
✅ Highly speculative ventures with a small likelihood of realizing a profit do have a profit motive (Dreicer v. Comm'r of Internal Revenue)
The expectation of profit does not need to be a reasonable one, but there needs to be a possibility of a big payday down the road that will make the venture profitable.
Example: Wildcat oil drilling is a highly-speculative venture in which the majority of ventures lose money, making it unlikely to realize a profit. However, there is a slim possibility of a very large payday. Case law supports this as a profit-motive business
The 9-Factor Test
IRS Regs 1.183 issued in 1972 created a "nine-factor test" to determine profit motive:
How the taxpayer carries on the activity (keeps accurate books and records)
Taxpayers expertise
Time & effort in carrying out the activity
Expectation that assets used in an activity, such as land, may appreciate in value.
Taxpayers success in other activities
Taxpayers history of income or losses from the activity
Relative amounts of profits & losses
Taxpayers financial status
Whether the activity provides a recreation or involves personal motives
The IRS weighs all the above factors when determining profit motive; no one factor is determinative.
Thoughts on the most important test (#1 - How the taxpayer carries out the activity)
Keep accounting records
Use separate accounts from personal accounts
Consider setting up LLC
Write a business plan
If you are not profitable, what do you need to do to become profitable?
Do the math to determine the best way to become profitable
Hire/purchase advice from experts to learn how to become profitable and keep proof that you implemented those decisions.
Make changes (and keep records of change) if several years of unprofitability
Other things to know:
Taxpayers bear the burden of proving that they engaged in the activity with an actual and honest objective of realizing a profit.
Items separately stated on separate schedules cannot be combined for 183 purposes, so be careful with that (for tax preparer).
In conclusion
There is a path to deducting loss activities that have a personal element. However, it is not for a client that does not want to put in the work necessary to substantiate the profit motive.
Ignoring the profit motive rules could lead to a substantial reassessment of tax and it's best to treadwith caution!