The Hobby-Loss Grouping Rules

Published Categorized as Federal Income Tax, Tax, Tax Loss
Irs “its All Or Nothing” Stance Often Helps Taxpayers
Irs “its All Or Nothing” Stance Often Helps Taxpayers

The IRS is not a government agency. It does not have to earn a profit. It does not even have to be concerned about keeping basic books and records. Unlike the standard that it imposes on even the smallest of business taxpayers, the IRS cannot produce anything close to a simple profit and loss statement or balance sheet. It cannot do so even when prompted by Congress.

This is what makes the so-called “hobby loss” rules such a farce. The IRS often audits small businesses and asserts that they are not operated for profit. The IRS does this to disallow the tax deductions that, from an economic standpoint, are actually incurred and lost. These cases are highly fact specific.

The recent Rabinowitz v. Commissioner, T.C. Memo. 2005-188, case provides an opportunity to consider one of these cases. The case highlights the grouping rules that taxpayers can use to help satisfy the hobby loss rules.

Facts & Procedural History

The taxpayers started a very successful womens apparel company. As the company grew, the couple purchased a jet. This allowed them to reach more markets and, apparently, the prestige gave them access to higher-end decision-makers for their business.

The couple chartered the jet to try to reduce its costs. This included making several changes over the years.

The IRS audited the taxpayer’s income returns for several years. The audit resulted in the IRS proposing to disallow the losses related to the jet charter activity. The IRS asserted that the taxpayers did not enter into the activity for a profit. Litigation ensued in the U.S. Tax Court.

The Hobby Loss Rules

Section 183 of the tax code outlines the rules for deducting losses from activities not engaged in for profit. It states that if an individual engages in an activity that is not engaged in for profit, no deduction attributable to that activity shall be allowed except as provided in Section 183.

Section 183(b) then goes on to explain that deductions that would be allowable regardless of whether the activity is engaged in for profit can be claimed under Section 183(b)(1). For example, expenses such as mortgage interest, property taxes, and insurance premiums are generally deductible regardless of whether the activity is engaged in for profit or not.

On the other hand, deductions that are only allowable if the activity is engaged in for profit can be claimed under Section 183(b)(2), but only to the extent that the gross income from the activity exceeds the deductions allowable under Section 183(b)(1). For example, expenses such as advertising, travel, and equipment depreciation may only be deductible if the taxpayer can show that the activity is engaged in for profit, and even then, the deductions may be limited to the extent that they do not exceed the gross income from the activity.

The nine hobby loss factors, also known as the “nine factors test,” are used by the IRS to determine whether an activity is engaged in for profit or is a hobby. The factors are:

  1. The manner in which the taxpayer carries on the activity.
  2. The expertise of the taxpayer or his or her advisors.
  3. The time and effort expended by the taxpayer in carrying on the activity.
  4. The expectation that assets used in the activity may appreciate in value.
  5. The success of the taxpayer in carrying on other similar or dissimilar activities.
  6. The taxpayer’s history of income or losses with respect to the activity.
  7. The amount of occasional profits, if any, which are earned.
  8. The financial status of the taxpayer.
  9. Any elements of personal pleasure or recreation associated with the activity.

The IRS considers all of these factors in determining whether the taxpayer engaged in the activity with the primary, predominant, or principal purpose of making a profit. Losses that are disallowed as hobby losses may still be allowable as start-up expenses in later tax years.

Grouping Activities for the Hobby Loss Rules

The court first considered whether the fashion business and jet charter business could be grouped as one activity for purposes of the hobby loss rules. The IRS argued that it could not.

The regulations say that multiple activities of a taxpayer may be treated as one activity if the activities are sufficiently interconnected. However, in determining whether activities can be treated as one, the degree of the organizational and economic interrelationship of the undertakings, the business purpose served by carrying on the undertakings separately or together, and the similarity of the undertakings are important factors to be considered. Additionally, the IRS is directed to accept a taxpayer’s characterization of two or more undertakings as one activity unless the characterization is artificial or unreasonable.

In applying these rules, the court found that the women’s apparel design and distribution company and their jet charter service could not be counted as one activity for purposes of applying Section 183. The court reached this conclusion because it found that the businesses did not share a close organizational or economic relationship and were not similar activities. The owners had a business purpose for treating them as separate entities, and there was no other organizational relationship between the two. Therefore, the court decided to examine whether the taxpayer engaged in the jet charter activity for profit without considering whether they engaged in the apparel business for profit. This, naturally, made it more difficult to satisfy the Section 183 hobby loss rules (this concept is similar for long production projects, which are also harder to qualify under the hobby loss rules).

The Court’s Holding

The court applied the nine hobby loss factors to just the jet charter business. This is the summary from the court:

Mr. Rabinowitz testified that petitioners thought they could enter the jet charter business, do it better than other charter companies, and make money while doing it. Petitioners used their considerable business skills to attempt to make the business profitable. Petitioners set competitive rates for the jet charter activity, advertised the jet charter activity, and solicited business from other jet owners. Petitioners kept voluminous books and records and maintained the FAA certificate required to sell charters to third parties. Petitioners made modifications to their business plan to attract more charter business. Petitioners successfully showed a general trend of decreasing losses throughout the relevant years, despite negative publicity and FAA-mandated additional safety requirements for their jet. Most importantly, we found petitioners’ testimony reliable and credible.

The court concluded that the nine nonexclusive factors and the facts and circumstances of this case showed that the taxpayers engaged in the jet charter activity with the primary, predominant and principal purpose and intent of realizing an economic profit independent of tax savings during the relevant years.

The Takeaway

While the IRS may determine that an activity is a hobby and, as such, losses are not currently deductible, the courts may not agree. Taxpayers can prevail in hobby loss cases as demonstrated by this court case. This case also shows why it is important to define the business as broadly as possible. Had the apparel business been grouped with the charter business, there would be no doubt that the hobby loss rules were satisfied. This is part of the tax planning that one should do to avoid the hobby loss rules.

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