IRS Classification of Business §162 or Hobby §183?
Business Owners will always explain to their accountant their business is not a hobby (it’s a for-profit business); however, the IRS doesn’t take a taxpayer’s statement of intent as the sole factor. There must be other factors to rely on besides a taxpayer’s verbal statement. The business vs. hobby issue has been problematic for the IRS. Now, more than ever, the service is beginning to scrutinize tax returns with losses, especially those with multi-year losses.
On Sept. 27, 2007, the U.S. Treasury Inspector General for Tax Administration issued a report stating that significant challenges exist in determining whether taxpayers with Schedule C losses are engaged in tax abuse. The report stated that many of the Schedule C businesses were not-for-profit, resulting in $2.8 billion in taxes avoided in 2005. Of the tax returns prepared in this area, 73 percent were prepared by tax professionals.
A taxpayer operating a for-profit business under IRC §162 should be able to prove that a bona fide business exists. It is presumed that a taxpayer is operating a for-profit business if there is a profit in three years out of five-year period. If the taxpayer is operating (like a horse business), there should be a profit in two years out of seven years.
The IRS and tax courts use the nine factors below to determine if a taxpayer is operating a for- profit business or if the business is a hobby being used to deduct expenses for tax avoidance purposes.
1. The business manner that a taxpayer carries on an activity.
2. The expertise of a taxpayer or advisor(s) involved in the business activity.
3. The time and effort a taxpayer allocates to the business activity.
4. Has the taxpayer had success with similar or dissimilar business activities in the past?
5. The history of income/loss for the business activity.
6. Are there occasional profits and, if so, how much are they?
7. The financial status of the tax payer, and does the taxpayer rely on this business activity or does the taxpayer have other sources of income?
8. Is there an expectation of asset appreciation for any assets involved in the business activity?
9. Are there elements of personal pleasure or recreation?
Not one factor of the nine will be a determining factor. Consideration should be given to all factors in making a proper determination.
Each taxpayer is unique and shouldn’t be compared to another taxpayer. For example, not every taxpayer will allocate the same amount of time, and not every taxpayer will have the same background, education or financial resources to allocate to their venture.
If a taxpayer’s activity has ongoing losses and doesn’t turn a profit in three years out of five years, the IRS may conduct an audit and make a determination that the activity is a hobby. The accountant and client should look to see if the losses are due to circumstances out of the control of the taxpayer, if they are due to start-up expenses, or whether the losses are because the activity is truly a hobby activity event.