Taxpayers can generally deduct ordinary and necessary expenses for conducting a trade or business or for the production of income.

But taxpayers who operate a hobby hoping to earn some income from it are faced with daunting rules regarding the taxation of the activity: If the activity is not engaged in for profit, it doesn’t qualify as a trade or business, and therefore any income received is reportable as “other income” on Form 1040, while losses are considered nondeductible personal expenses. Expenses are deductible, but only to the extent that the activity generates income, and the deduction is limited by the 2 percent adjusted gross income floor for miscellaneous itemized deductions.

Does it make any difference if the activity is performed within a corporation? No, according to a federal appeals court.

In a recent decision that is instructive as to the importance of profit motive to have a trade or business (and therefore not be subject to the hobby loss rule limitations), the Eighth Circuit declined to overturn the Tax Court, even though it found evidence of a profit motive in the taxpayer’s hobby. And the fact that it was part of a legitimate corporation didn’t affect the outcome.

The taxpayer, Debra Dursky, operated DKD Corp. out of her personal residence in West Des Moines, Iowa. DKD’s principal source of income was information technology consulting.

DKD also operated a “cattery” to breed, show and sell pedigree show kittens. Prior to 2003, Dursky and a friend operated the cattery as an informal, unincorporated venture. When she decided to expand the cattery operation, to build its reputation and to increase profits, DKD assumed responsibility for the cattery. Dursky and her friend continued to manage the cattery from Dursky’s home.

To enhance the cattery’s national reputation, DKD entered its kittens in national competitions, winning four championships between 2003 and 2005. During the tax years in question, DKD reimbursed Dursky slightly over $60,000 per year for out-of-pocket expenses such as travel and competition costs, veterinary bills, food, grooming, and supplies. The cattery produced no revenue in 2003, $250 in 2004 from the sale of three cats, and $1,525 in 2005 from the sale of eight cats.

In 2006, DKD abandoned the operation, and Dursky resumed managing the cattery as a separate, unincorporated venture.

The Tax Court disallowed DKD’s claimed deductions for operational expenses, finding the activity was a personal hobby and not a trade or business. Even though the circuit court disagreed with the Tax Court that there was no evidence that DKD intended to make a profit from the cattery activity, it affirmed the decision. It said that Dursky’s testimony was corroborated to some extent because DKD operated a Web site marketing its kittens, successfully raised four national champion kittens, and earned some income in 2004 and 2005.

“The mere fact that DKD’s cattery expenses vastly exceeded its income is not sufficient to disprove the existence of a genuine profit motive,” the court stated. It also would not be correct for the tax court to disallow a “trade or business” deduction merely because, in the court’s view, the business venture was unlikely to produce the desired profits, according to the circuit court.

The rule is that the Tax Court should find that the trade or business venture lacked a genuine profit motive only if it finds that the taxpayer lacked a good-faith, subjective intention to make a profit, the court explained. The taxpayer need not have a reasonable expectation of a profit but must have a good-faith intention of making a profit or of producing income.

So, although it disagreed with some of the Tax Court’s reasoning, the circuit court affirmed it because it could not say that the Tax Court clearly erred in finding that DKD failed to carry its burden of establishing that, for each of the years at issue, its cattery activity constituted a trade or business.

Even though the cattery had revenue in two of the three years it was a part of the corporation, it did not actually turn a profit. Had it done so, it would have been successful in its effort to be classified as a business, since an activity is presumed to be for profit if it makes a profit in at least three of the last five tax years, including the current year.

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