Business or Hobby: Which is It?

1. Business or Hobby: Which is It? All audio is streamed through your computer speakers. There were  several attendance verification questions presented during the LIVE webinar to qualify for CPE of the LIVE event only. For the archived/recorded version of this webinar, the link at the end of this presentation will be to final exam on the topics and learning objectives covered during this webinar plus there are also 3 online  review questions to answer per hour.

2. Business or Hobby That is the Question IRC §162 & 183 Presented by Andrew G. Poulos, EA, ABA, ATP

3. Learning Objectives Upon completion of this webinar you will be able to: • Assess and determine if your clients are operating a real business vs. a hobby.  • List nine factors to consider for differentiating between business vs. hobby losses. • Implement the use of a list of key questions and items to help analyze and distinguish between a business or a hobby. • Recognize the guidelines needed to understand the differences in IRC Sec. 162 vs. IRC Sec. 183. • Determine which category a venture falls in, and what the tax effects are if for operating a hobby vs. a business.   • Recognize the hobby loss limitation rules and calculate how to deduct expenses for a hobby versus a business. 

4. TIGTA Report • 9/27/07 – “Significant Challenges Exist in Determining Whether Taxpayers with Schedule C Losses are Engaged in Tax Abuse” • Review looked at high income SB/SE taxpayers • Total income of $100,000 or more

5. TIGTA Report Continues • Losses reported on Schedule C of Form 1040 • Activities considered to be NOT for profit

6. TIGTA Audit Results • Hobby expenses limited to hobby income • 1.5M with significant other income filed Schedule C, only losses for 2002-2005 • 73% prepared by tax professionals • 2.8B in taxes avoided in 2005

7. Notes in TIGTA Report • Only Schedule C losses included • 4 years of consecutive losses • Total income sources of $100,000 or greater • No Schedule F, only Form 1040

8. Changes Are Needed “To prevent taxpayers from continually deducting losses in potentially not-for-profit activities to reduce their tax liabilities.”

9. Is Hobby a For-Profit Endeavor? • FS-2008-23 – June 2008 • IRS reminds taxpayers with guidelines • IRC Section 183 – Hobby Loss Rule • In general: deductions allowed for ordinary and necessary business expenses

10. IRC Sec. 162 Considerations • Ordinary and necessary expenses – trade or business • Ordinary – common and accepted in the trade or business of taxpayer • Necessary – appropriate for the trade or business of taxpayer

11. Is Activity Important? • Qualifies as business – If carried on with actual and honest expectation of earning a profit • Activity not for profit – Losses may not be used to offset other income • Income – Related Expense = Loss

12. Is it a Business Expense? • Must meet requirements of: a) Carrying on Trade or Business b) For Production of Income • Failing to meet either, consider IRC Sec. 183

13. For Consideration • Relevant Factors • Include all pertinent facts • IRC 183 – Activities Not Engaged in For Profit – Hobby Loss

14. We Must Understand • Understand deductible business expenses vs. • Non-deductible hobby expenses

15. Distinguishing Between • Business Activity – IRC § 162 Expenses • Non-business “for profit” – IRC § 212 Expenses • Not engaged in for profit – IRC § 183 limitations on deductions • Personal activity – Deductions disallowed by IRC § 262 except to extent not otherwise allowable

16. Applicable Code Sections • Sec. 162 - Trade or Business Expenses Deduction for all ordinary and necessary expenses • Sec. 212 – Expenses for production of Income – for individuals: 1) Production/collection of income, 2) Management/conservation/maintenance of property held for production of income, and 3) Connection with determination, collection, or refund of any tax

17. Sec. 183 – Activities Not Engaged in for Profit • Individual or S Corp – If NOT engaged in for Profit there is NO deduction • Exceptions: • Deductions allowed without engagement for profit • Deduction equals to deductions allowed if FOR PROFIT, if gross income exceeds deductions allowed without engagement for profit

18. Presumption • Profit in 3 out of 5 years • Profit 2 out of 7 years - Horse Business • Presumed Activity for Profit • Unless IRS establishes to the contrary

19. 9 Factors To Consider • Manner taxpayer carries on activity • Expertise of taxpayer or advisors • Time and Effort • Expectation of Asset appreciation • Success with similar or dissimilar activities • History of income/loss • Occasional profits • Financial status • Elements of personal pleasure or recreation

20. Factors to Determine if Activity Engaged In for Profit • Do time and effort indicate intent for profit? • Do you depend on income from activity? • Are losses due to circumstances out of your control or due to start-up expenses? • Have you changed operations to improve profitability?

21. Additional Factors • Is your knowledge adequate to make this a profitable activity? • What about profit in the past with similar activities? • Was there a profit in some years? • Any anticipation of profit in future from asset appreciation?

22. Practitioner Alert • Activity is “presumed” for profit if: • Profit in at least 3 of last 5 years • Includes current year • Profit in at least 2 of last 7 years if horses

23. If Activity Not for Profit • Losses not used to offset other income. • Losses occur when expenses exceed income. • Limit applies to: Individuals Partnerships Estates Trusts S Corporations NOT C Corps

24. Allowable Hobby DeductionsUnder IRC 183 • Activity NOT carried on for profit • Allowable deductions cannot exceed income

25. Deductions for Hobby Activities • Schedule A, Form 1040 • Deduct in following order: • Full deduction for home mortgage interest and taxes • Deductions not resulting in basis adjustment, advertising, insurance premiums and wages may be taken to extent gross income is more than deductions under 1

26. Deductions for Hobby Activities 3. Deductions that reduce basis taken last Depreciation and Amortization Only to extent gross income is more than deductions taken in step 1 & 2

27. History in a Snap Shot • Revenue Act of 1943 as IRC § 270 • Intension – limit individuals with multiple sources of income to reduce overall tax liabilities • IRC § 270 repealed by Tax Reform Act of 1969 for years after 12/31/69 • Replaced with IRC § 183

28. IRS Code § 183 • Applies to Individuals, Partnerships, S Corps and Trusts and Estates • Not C Corporations • No IRC or Regulations defines – just guidance • Historically a difficult issue

29. Generally IRC allows deduction of expenses: 1) In trade or business – IRC § 162 2) Production or collection of income, management, conservation or maintenance of property held for production of income – IRC § 212

30. Honest Objective of Making a Profit • Keanini v. Comr., 94 T.C. 41 (1990) citing • Golanty v. Comr., 72 T.C. 411, 425 (1979), aff’d without published opinion, 647 F. 2d 170 (9th Cir. 1981) • Dreicer v. Comr., 78 T. C. 642 (1982), aff’d without opinion, 702 F. 2d 1205 (D.C. Cir. 1983)

31. Taxpayers Bear Burden of Proof • Hendricks v. Comr. - 1994 • Comr. v. Groetzinger – 1987 • Bot v. Comr. – 2003 • Am. Acad. Of Family Physicians v. U.S. - 1996

32. Taxpayer MUST • Devote time to business • Honest belief profitable in the future • Show what projected profit is to be

33. NOT Engaged In for Profit • § 183(b) allows: • Deductions allowable without regard to activity for profit • Deductions for amounts allowable if engaged in for profit, to extent of gross income remaining

34. Treas. Regs § 1.183-1(e) Gross Income: All income, including sales, exchanges or dispositions and all other gross receipts Reduced by COGS Personal or nondeductible items will be excluded by IRS Examiner.

35. Other Tax Return Items Affected • SE tax • Deduction for Health Insurance Premiums • AMT • Itemized Deductions • AGI • Personal exemption phase out • Roth IRA Contributions

36. CAUTION AGI affects many items: Rental losses Medical expense Casualty losses Miscellaneous deductions Adoption expense credit Interest on education loans

37. AMT Alert Problem with Code § 183 Many not-for-profit expenses are reported on Schedule A – Miscellaneous Not deductible for AMT purposes

38. Treas. Reg. § 1.183-2(b) • 9 Factors cited in Reg. – non-exclusive • Manner in which conducted • Expertise of taxpayer or advisor(s) • Time and effort expended • Expectation assets may appreciate in value

39. Reg. Continued • Success of taxpayer in similar or dissimilar activities • Taxpayer’s history of income or loss with respect to activity • Amount of occasional profits, if any • Financial status of taxpayer, and • Elements of personal pleasure or recreation

40. How Many Factors Needed? • No single factor controls • Number does not control • More weight given to objective facts than to taxpayer’s statement of intent • Dreicer v. Comr. - 1982

41. Review Questions for Self Study CPE: Now’s the time to answer the first set of review questions. Click here: http://www.proprofs.com/quiz-school/story.php?title=NTc1NzQz

42. Profit in Early Years • No blank check for future losses • Profit objective in early years no guarantee not treated as not-for-profit in later years • Daugherty v. Comr. - 1983 • Dennis v. Comr. - 1984

43. Presumption Under § 183(d) Safe Harbor: Engaged in activity for profit 3 out of 5 years 2 out of 7 for horse activity

44. Code § 183(e) - Election Taxpayer is allowed to postpone determination of § 183(d) presumption.

45. Code § 162 • Allows deductions for “trade or business” ordinary and necessary expenses • Bona fide business must exist • Expenses appropriate to carrying on “trade or business” and not capital expenditure. Not with respect to residence – exception IRC § 280A • Welch v. Helvering - 1933

46. Multiple Activities • Treas. Regs. § 1.183-1(d) • 2 or more separate activities not aggregated for not-for-profit determination • Unless sufficiently interconnected

47. Are Activities Interconnected? • Based upon all facts and circumstances • Degree of organizational and economic interrelationship, • Business purpose for various activity, and • Similarity of various undertakings. Commissioner generally accepts taxpayers justification of interconnected activities UNLESS cannot be supported and each activity treated separately.

48. Taxpayer’s Subject to § 183 • Individuals – IRC § 183(a) • S corporations – IRC § 183(a) – Treas. Regs. § 1.183-1(f) • Partnerships – reflected in partnership’s distributive shares – IRC § 703(a) • Trusts and Estates – IRC § 641(b)

49. C Corporations The provisions of IRC § 183 do not apply to C corporations.

50. Election to Postpone Determination • IRC § 183(e) • Election to postpone determination of presumption until close of 4th taxable year or 6th taxable for horse activities • Following 1st taxable year engaged in activity.