Section 183’s recreational loss provisions focus primarily on Section 162 and its “ordinary and necessary” criteria for the deduction of business expenses and losses. It also mentions the capital expenditure provisions of Section 212. If your activity is considered a non-profit rather than a business, tax rules may determine taxable income in some years while prohibiting losses in others. years, generally in the event of non-compliance with Article 162.
The basics of hobby waste rules
The issue of lost hobbies has always focused on activities such as farming and horse racing, but the rules are not limited to certain types of businesses. In modern times, for example, occasional use of eBay would not normally rise to the level of a trade or business. However, it is also entirely possible that recurring use of eBay could be considered a trade or business. On the other hand, selling your old golf equipment on eBay would not turn a non-deductible hobby loss into a business loss.
Many factors are considered to distinguish a business from a non-profit activity. There are general criteria and rules, but one of the advantages for taxpayers is that profits made in three or more consecutive years out of the five ending with the current year result in a presumption of profit.
A key concept here is ‘activity’. Two or more activities generally cannot be treated as one, but it may be possible to group them together if they are closely related. In general, it can be relatively easy to argue for the aggregation of activities. (See Publication 5558, p. 21, emphasizing the “organizational and economic interrelationship”, the business purpose of the activities being distinct or considered one and the similarity of the activities.)
Early phase issues may arise, including an activity changing from a hobby to a business.
When section 183 applies, instead of general deductibility, questions of the order of specific deductions are addressed. Category 1 includes deductible items regardless of the for-profit question (eg, mortgage interest). Because the Tax Cuts and Jobs Act repealed various itemized deductions for tax years beginning after 2017 and before 2026, category 2 and 3 expenses are not deductible as we write in 2022. Hobby losses are actually less deductible in our current environment due to this temporary situation. restriction.
Other potentially important aspects of the business versus hobby issue include self-employment tax, Medicare tax, and related deductions.
Distinguish a company
The regulations provide the following nine general guidelines for a for-profit business.
1. How to do the trade or business, including good books, being able to point to profitable businesses similar to yours, adapting to new techniques, scrapping what hasn’t worked, etc. , will be considered.
2. Preparation for activity by study and consultation may indicate a profit motive. Disregarding the consultant’s advice can be negative, but there is also the argument of the new approach.
3. Activity level, such as spending a lot of time or withdrawing from another occupation, can be an indication of business activity. Limited time is a circumstance in which a competent helper can also help prove a motive for profit.
4. Expected appreciation of values, including land, can be an important factor.
5. A track record of business success can be helpful; for example, turning a previous loss-making business into profitability.
6. Staying too long in loss mode is a negative point, but special circumstances can also be pointed out. In general, the COVID-19 pandemic and other extraordinary issues may indicate special circumstances to stay with an activity.
7. The dimensions of positive and negative aspects are important; for example, small losses and big profits in the context of the resources devoted to the activity.
8. Financial status may be a factor; for example, the wealthy invest, lose and profit from the effort.
9. Recreational or personal elements are negative. If the activity tends not to be fun (the author’s paraphrase “has no appeal other than profit”), it is helpful. An interesting sentence in this part of the regulations states: “It is not necessary, however, that an activity be carried on with the exclusive intention of obtaining a profit or with the intention of maximizing profits.
An IRS publication discussing these factors advises the IRS auditor to educate themselves on loans and financing. At the same time, he advises IRS officers to stay focused on the big picture and therefore the multitude of factors.
In planning to defend a client on this issue, it may also be helpful to educate the client on tax rules and the need for profit. IRS auditors are advised to be prepared for the taxpayer’s counsel to argue that the losses can be explained as start-up phase losses. They are also advised to insist on talking to the taxpayer about issues such as start-up losses, even if the adviser prefers to protect the taxpayer. The IRS insists on these “objective factors” while qualifying the subject as “highly subjective”.
Prepare for a hobby waste challenge
A taxpayer victory 10 years ago highlighted the following factors. The context was a primarily lawyer turned documentary filmmaker claiming significant tax losses: This taxpayer:
- Maintain detailed business records,
- Write and modify a business plan,
- External funding sought,
- Hired an accountant,
- Obtained liability insurance, and
- I solicited feedback from industry professionals.
(“New Case Highlights Filmmaker’s ‘Hobby Losses'”, Berry, Accountingweb.com, 4/24/12.)
Cases of hobby loss involve all kinds of businesses (or hobbies), some common and some quite unusual. A recent Tax Court decision, another victory for taxpayers, found that losses from raising miniature donkeys were business losses. (Huff v. Commissioner, TC Memo 2021-140, 12/21/21.)
Each company may very well have unique characteristics that require special attention.
Loss planning
Net operating loss carryback legislation may be unusual. An important part of the planning here is that net operating losses are basically not subject to carryback from 2022. There is no net operating loss carryback to mitigate annual accounting in this regarding the self-employment tax and the Medicare tax.
Section 461(l) now limits the ability to set off non-trading income for more than $250,000 of business losses, or $500,000 of business losses if filed jointly. This relatively recent concept was enacted, then suspended, but has been back since last year. These dollar thresholds are already adjusted annually for inflation.
Tax loss planning and deduction planning may have new limits that are important considerations. Here, the planning takes into account the three-year presumption rule.
Final Thoughts
Many details are involved in planning for potential business losses. However, the tax professional should keep in mind the underlying importance of overriding any business versus hobby issues that may be raised by the IRS or state tax authorities. An important part of this planning usually includes client education, as well as projecting client numbers.
