Internal Revenue Code Section 183 (Activities Not Engaged in For Profit) limits deductions that can be claimed when an activity is not engaged in for profit. IRC 183 is sometimes referred to as the “hobby loss rule.”
Among the factors the IRS considers when auditing a business that has recurring losses are the following:
1 - Has the taxpayer made a profit from this activity in any prior years? If so, how frequently has the activity made a profit and how substantial were the profits?
2 - Does the taxpayer depend on generating an income from this activity?
3 - Has the taxpayer allocated enough time and effort in the activity to support that he/she has an intention to make a profit from the activity?
4 - If the activity itself does not make a profit, does the taxpayer reasonably anticipate making a profit from the appreciation of the assets used in the activity?
5 - Does the profit motive of the activity outweigh the recreational aspects of the activity?
6 - Is there an appearance that the taxpayer has a tax strategy of losing money in this activity to reduce their taxes from their primary source of income?
7 - Is this activity used to hire family members who are in lower tax brackets?
8 - Has the taxpayer generated a profit from similar activities in the past?
9 - If the activity is producing a loss, are the losses due to circumstances beyond the control of the taxpayer, or are these losses occurring during the initial phase of the business start-up?
10 - If the activity is generating losses, has the taxpayer made efforts to make changes in the operation to improve the profitability?
11 - Does the taxpayer have the necessary business knowledge to carry on this activity in a successful and profitable manner? Or has the taxpayer consulted with others who can give them the needed direction and coaching to do so?
The safe harbor for the taxpayer is whether the activity has made a profit in at least three of the last five tax years. If so, the burden of proof shifts from the taxpayer to the IRS (or if the activity is primarily that of breeding, showing, training or racing horses, the activity is expected to make a profit two of the last seven years). This basic presumption is founded in the first four questions above. However, something very critical in the overall determination is founded in the last three questions which basically are asking the taxpayer, do you have a business plan?
Of course, many small business owners may make the observation that they do not have a formal business plan. An article published at http://www.entrepreneur.com/article/217768 indicates "research at Babson College, regarded as having one of the top entrepreneurship programs in the country, finds no statistical correlation between a startup firm's ultimate revenue or net income and the supposedly requisite written business plan." - "Myth of the Business Plan" by Kate Lister (12/20/2010)
The article continues on to say: "Should you agonize over writing everything down in a format that some scholarly journal says is the way to do it? 'Unless you're entering a business plan competition, no,' says Julian Lange, a co-author of the Babson study. 'Your time would be better spent out on the street, learning all you can from potential customers.'"
In contrast, Winston Churchill during World War II is quoted as having said, "He who fails to plan is planning to fail." And Alan Lakein, the writer of several self-help books on time management from the 1970s, is attributed the quote: "Failing to plan is planning to fail."
Further, the Small Business Administration's list of the top ten reasons for business failure are: 1) lack of experience, 2) insufficient capital, 3) poor location, 4) poor inventory management, 5) over-investment in fixed assets, 6) poor credit arrangements, 7) personal use of business funds, 8) unexpected growth, 9) competition, and 10) low sales.
It would appear to be an over simplification of the issue to say that every business should have a business plan in order to avoid the IRS attempting to classify it as a hobby loss. Because clearly not all small businesses have a business plan and as documented by the study at Babson College a business plan is not in and of itself the answer. If the designation of hobby loss could be avoided simply by having a business plan, then clearly CPAs everywhere would be making sure any taxpayer with a business losing money would have a written business plan.
Certainly, the determination of whether an activity is engaged in for profit is based on the facts and circumstances of each case. The fundamental issue is for the taxpayer to establish that he/she has an intent to make a profit and is making every effort to make a profit. When the activity does not make a profit, what analysis has the taxpayer made of the operations, and what corrective actions are made? Further, has the taxpayer consulted with experts knowledgeable in the field to determine what corrective action should be taken? Does the taxpayer spend sufficient time working on fine-tuning the operation to move into a profitable mode?
Essentially, is the activity operated in a business-like manner? Furthermore, the IRS will be looking to determine the amount of time spent in the activity and will ask fundamental questions such as is the activity substantial enough to ever make a profit? Common sense would beg the question of any taxpayer, if a business is continually losing money, why would you not shut the business down? Or as indicated above, does your hobby have a plan that would lead and direct it into a profitable mode of operations?
Jerry Love is the sole owner of Jerry Love CPA, LLC in Abilene, Texas. He graduated from Abilene Christian University. In addition to being a CPA, he has also earned the designations of PFS, CFP, CVA, ABV, CITP, CFF, and CFFA. In 2006-07, Jerry was the Chairman of the Texas Society of CPAs.
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