The IRS is a silent partner in every business venture. It is quick to take its share of profits when a business venture succeeds. The IRS is often not a good business partner. It often refuses to share in the losses during the down times.
This unequal treatment often comes up when the taxpayer reports a tax loss on their income tax returns. The IRS often audits tax losses and disallows the tax losses. There are several tax laws that allow the IRS to do this. One of them is the hobby loss rules. These rules allow the IRS to say that the business is a hobby and not a business and, as such, the expenses are basically non-deductible personal expenses.
There have been numerous court cases involving hobby losses. We have covered several of them on this website (such as this one comparing the hobby loss rules to the start-up rules and this one about planning for the hobby loss rules). The recent Mazotti v. Commissioner, T.C. Memo. 2024-75, case provides an opportunity to revisit the rules with a focus on what to do if the IRS pulls your tax return for audit and you have a tax loss that could potentially be labeled a hobby loss. The case involves a writer who deducted losses for her writing activities.
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Facts & Procedural History
The taxpayer and her husband filed joint tax returns for 2018, 2019, and 2020. They reported substantial losses on Schedule C for the wife’s “writer-researcher” activities each year. The tax losses were $61,493 in 2018, $63,004 in 2019, and $61,470 in 2020, with corresponding income of only $30, $15, and $1,000 for each year.
The IRS audited the tax returns and determined that the wife’s activities were not engaged in for profit. The IRS issued a notice of deficiency to disallow the tax deductions for this activity. This led to the U.S. Tax Court litigation and court opinion. The question for the court was whether the tax loss was not allowable as the activity was a hobby that was not entered into for a profit.
The Trade or Business Rules
Before getting into the hobby loss rules, we first have to consider the trade or business and investment rules. These are the rules that allow expenses as tax deductions for income tax purposes. The rules are found in Section 162 and Section 212.
Section 162 allows deductions for ordinary and necessary expenses paid or incurred in carrying on a trade or business. This is the catch-all provision that most business expenses are deducted under. The code itself provides examples of expenses, such as expenses incurred to earn a salary, travel expenses, and rental expenses.
To qualify under Section 162, the taxpayer to have a “trade or business.” This term is not defined in the Code, but it generally means an activity that is for-profit that is engaged in regularly and continuously. It can even include a real estate trade or business.
For an expense to be deductible under Section 162, it also has to be an “ordinary and necessary” expense. This means that the expense must be common and accepted in the taxpayer’s trade or business (ordinary) and appropriate and helpful for the development of the business (necessary). This doesn’t mean the expense must be indispensable, but it should have a reasonable relationship to the business.
While Section 162 applies to trades or businesses, Section 212 allows for deductions of expenses incurred for the production of income or management of property held for the production of income. The key difference is that Section 212 expenses vs. Section 162 expenses is the level of activity of the owner of the activity.
While both Section 162 and Section 212 expenses are deductible for income tax purposes, there are different limitations that apply to each deduction. For example, Section 212 expenses are generally subject to the 2% floor on miscellaneous itemized deductions, which were suspended by the Tax Cuts and Jobs Act through 2025. This effectively eliminated some expenses if they do not qualify under Section 162.
The Hobby Loss Rules
Even if an expense is deductible under Section 162 or Section 212, it may still be reduced or eliminated by other tax laws. The Section 183 hobby loss rules provide an example of this.
Section 183 limits deductions that would otherwise be deductible under Section 162 or Section 212 for activities not engaged in for profit. That is what the statute actually says, i.e., no tax deductions for an activity not engaged in for a profit. If the hobby loss rules are not satisfied, the expenses that resulted in the loss are not deductible for income tax purposes in excess of the income earned from that activity.
Unlike business losses that are limited by most other tax rules, hobby losses cannot be carried forward to future years. The expenses are lost altogether for tax purposes.
Applying the Hobby Loss Rules
The hobby loss rules require a four-step analysis. First, one has to determine whether there are legitimate expenses that qualify under Section 162 or Section 212.
Second, one has to determine whether there is a loss in the current year. Absent a loss, one does not have to worry about the hobby loss rules.
Thrid, if there are deductible expenses and there is a loss in the current year, then one has to consider whether the three-year presumption rules apply. The three-year presumption rules say that there is a presumption of a profit motive in the current year if an activity produces profit in at least three of the last five tax years (two of seven for horse-related activities). This presumption is helpful for taxpayers who can demonstrate a pattern of profitability, but who happen to have a tax loss in the current year. So a taxpayer whose business is profitable for some years and not others can use this to avoid the IRS asserting that their loss is not allowable as it is a hobby loss.
Last, absent the benefit of the presumption, the regulations set out a 9-factor test to determine whether an activity is for profit or a so-called hobby. These rules are found in Treasury Regulation § 1.183-2(b), which says that the following factors are to be considered:
- Elements of personal pleasure or recreation
- The manner in which the taxpayer carries on the activity
- The expertise of the taxpayer or his advisors
- The time and effort expended by the taxpayer in carrying on the activity
- Expectation that assets used in activity may appreciate in value
- The success of the taxpayer in carrying on other similar or dissimilar activities
- The taxpayer’s history of income or losses with respect to the activity
- The amount of occasional profits, if any, which are earned
- The financial status of the taxpayer
We’ll address these factors later, but note that the courts have stated that no one factor is determinative. With that said, the courts have generally concluded that activities are hobbies if they have an element of pleasure or recreation. Examples include horse racing, car racing, classic car restoration, and sporting activities.
Documenting the Nine Factors
When the courts are required to address factors, such as the 9-factor hobby loss rules, that calls into question documentation. Documentation is key. It is central to just about every published court case involving hobby losses. The Mazotti case provides a prime example of this.
Here is a summary of the court’s analysis of the Mazotti case:
- The taxpayer had no business plan and failed to keep accurate books and records.
- Despite claims of lifelong writing experience, the taxpayer provided no evidence of studying the business aspects of writing.
- The court found the taxpayer’s testimony about time spent on writing activities to be self-serving and unconvincing due to lack of documentation.
- There was no evidence of business assets that could appreciate in value.
- No documented evidence of past success in similar ventures was presented.
- Nearly 30 years of consistent losses were documented, strongly suggesting a lack of profit motive.
- The minimal documented income ($1,045 total over three years) compared to $187,012 in expenses was damaging to her case.
- While the taxpayer didn’t have substantial income, the tax benefits from the reported losses were significant.
- The court noted the clear personal enjoyment derived from the activities, including family vacations claimed as “research trips.”
Thus, the tax court found that nearly all factors weighed against the taxpayers. The court case noted numerous times that there was no documentation and evidence to support a profit motive.
There are numerous ways taxpayers can address this. The primary way is to simply keep good records. This includes everything from timesheet records, travel or trip logs, etc. This presumes that the taxpayer is also carrying on the activity in a business-like manner. This means that they keep separate bank accounts to capture the income and expenses, maintain insurance (if appropriate), have a written business plan, etc.
Postponing the Determination
Other than pulling together records during an audit, what else can you do if you are selected for audit and have a loss that the IRS is likely to argue is from a hobby? One consideration is to postpone the determination. The IRS has a specific form and procedure for this purpose.
The taxpayer can initiate this process by providing the IRS auditor with Form 5213. This form allows taxpayers to request that the IRS auditor postpone the determination of whether the three-of-five presumption applies until the fourth tax year (or sixth for horse-related activities) after the year the taxpayer first engages in the activity. This gives the taxpayer time to take steps to ensure their business becomes profitable and to implement more business-like practices.
While this strategy can be helpful in some cases, it does have a few drawbacks. One significant drawback is that the taxpayer must agree to extend the statute of limitations for the IRS to assess taxes related to the activity. This extension gives the IRS agent the ability to wait until later years to make a determination, without needing to close the audit immediately.
Another potential drawback is that the IRS agent may simply not agree to hold the audit open. In such cases, the taxpayer may find themselves back at square one, needing to defend their business losses without the benefit of additional time to demonstrate profitability.
Grouping Activities to Meet the Tests
The taxpayer may also consider the grouping rules. These rules, found in Treasury Regulation § 1.183-1(d), allow taxpayers to group multiple activities into a single activity for purposes of applying the hobby loss rules. This can allow taxpayers who engage in multiple related activities to avoid the hobby loss rules if some of the activities are profitable while others are not.
The regulation states that “generally, the most significant facts and circumstances in making this determination are the degree of organizational and economic interrelationship of various undertakings, the business purpose which is (or might be) served by carrying on the various undertakings separately or together in a trade or business or in an investment setting, and the similarity of various undertakings.”
For example, a taxpayer who operates a farm might have separate activities for growing crops, raising livestock, and offering farm tours. While the farm tours alone might not be profitable, when grouped with the other farming activities, the overall enterprise might show a profit motive.
The courts have said that taxpayers cannot group profitable activities with unprofitable ones solely to avoid the hobby loss rules. You can read about a case about grouping here. There must be a legitimate business reason for the grouping. Here are a few of the considerations for grouping activities given this interpretation:
- Economic Interrelationship: The activities should have some economic connection. This could include shared resources, overlapping customer bases, or complementary products or services.
- Business Purpose: There should be a clear business reason for conducting the activities together. This might include economies of scale, synergies between the activities, or a more comprehensive offering to customers.
- Similarity of Undertakings: While not required, similar activities are more likely to be grouped successfully. However, dissimilar activities can be grouped if there’s a strong economic interrelationship and business purpose.
- Consistency: Once activities are grouped, the taxpayer should maintain this grouping consistently across tax years unless there’s a change in facts and circumstances.
- Documentation: As with other aspects of proving a profit motive, it’s crucial to document the reasons for grouping activities. This might include a written business plan explaining how the activities work together, shared marketing materials, or financial projections showing the combined profitability of the grouped activities.
In the context of the Mazotti case, if the taxpayer had other writing-related activities that were profitable (such as freelance editing or teaching writing workshops), she might have been able to group these with her less profitable writing activities. This may even include grouping them with her work as an employee as a teacher. However, given the lack of documentation and business-like conduct noted by the court, such a grouping strategy might still have faced challenges.
The Takeaway
This case provides a prime example of how the IRS scrutinizes business losses. Absent a history of profits, the IRS will often assert that the losses are not allowable as the activity is a hobby and not a business. The case also shows how important it is to maintain records to support a profit motive. This is particularly true for activities that could be perceived as hobbies, such as the writing activity in this case.
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