Tax Deductions for Hobby Survives IRS Scrutiny

Published Categorized as Federal Income Tax, Tax, Tax Deductions, Tax Loss 1 Comment on Tax Deductions for Hobby Survives IRS Scrutiny
Fines Or Sanctions Paid To Finra Are Not Deductible
Fines Or Sanctions Paid To Finra Are Not Deductible

There are quite a few cases where the IRS disallowed loss deductions for “hobbies.” There are also quite a few cases where the courts have upheld the IRS’s position. These cases are decided based on the facts and how the courts interpret these facts. The facts in Main v. Commissioner, T.C. Memo. 2016-127, provide a good example of what types of facts taxpayers should emphasize during the course of IRS audits in which the IRS raises the hobby loss rules.

Facts & Procedural History

Mr. Main is a patent attorney in California.

His patent business experienced a downturn in 2009.

He also had an automobile business, which involved buying, restoring, and selling 1955 and 1956 Plymouth cars.

He advertised online, in print publications, and at live events and traveled throughout the western United States to acquire bargain-priced Plymouths.

His inventory, at its peak, reached 40 cars, which he stored in a large two-story barn on his ranch in Livermore, California.

He also contracted with a retired jewelry maker and a rubber manufacturer to produce and supply unavailable parts. These parts were used to renovate the cars in his inventory or sold to other Plymouth restorers. He discovered, however, that the cost of producing these parts exceeded the related sales revenue and ceased contracting for their production.

He spent $27,900 to build a separate garage at his residence and moved the Plymouths from storage to the separate garage and conducted his automobile activity from that location.

The IRS audited Mr. Main’s 2009 tax return and disallowed his automobile activity deductions on the grounds that Mr. Main lacked the requisite profit objective.

What Rules Apply When Questioning Profit Motive?

The hobby loss rules limit deductions relating to an activity not engaged in for profit. There are nine factors that are to be considered in whether an activity is engaged in for a profit:

  • manner in which the taxpayers carry on the activity,
  • expertise of the taxpayers or that of their advisers,
  • time and effort expended on the activity,
  • expectation that assets used in the activity may appreciate in value,
  • success of the taxpayers in carrying on other similar or dissimilar activities,
  • history of income or losses with respect to the activity,
  • amount of occasional profits, if any, from the activity,
  • financial status of the taxpayers, and
  • any elements of personal pleasure or recreation.

The IRS frequently asserts that these factors are not met when there is some recreation or pleasure aspect of the business activity. Businesses related to travel and entertainment are examples.

Once the IRS asserts that these factors show that there is no profit motive, the taxpayer has the burden to show otherwise. The courts that have applied these factors have reached mixed conclusions based on their interpretation of the facts in each case. The court opinions are typically pretty lengthy, as they address each factor in detail.

The court opinion in Main is short. The court gets right to the point, concluding that Mr. Main’s business activity was engaged in for a profit. The court had this to say about Mr. Main’s business activities:

Petitioner undoubtedly enjoyed working with Plymouths. See sec. 1.183-2(b)(9), Income Tax Regs. Although his manner of carrying on this activity was unsophisticated, it was businesslike. He had experience operating a business and expertise relating to Plymouths; advertised online, in print, and at live events; traveled outside California to acquire cars at bargain prices; contracted with third parties to manufacture parts for him to resell and use in restorations; and abandoned unprofitable aspects of his automobile activity (i.e., he downsized his inventory and stopped contracting for manufactured parts). Furthermore, he devoted considerable time to, and handled all material aspects of, his automobile activity. Lastly, petitioner’s patent business was undergoing a downturn during the year in issue, and petitioner, a prudent businessman, would not have squandered his hard earned money on an expensive hobby. In short, petitioner’s automobile activity was a business, and his primary objective was to make a profit.

The Takeaway

This is the type of court decision is the end goal for taxpayers whose deductions were limited by the hobby loss rules. It illustrates the facts that taxpayers should generally emphasize during the audit, and if necessary, the appeals and litigation process.

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