The Internal Revenue Service could be doing more to identify and examine taxpayers who may be deducting hobby losses to offset their actual income, according to a new report.

The report, from the Treasury Inspector General for Tax Administration, found that the IRS’s methods for identifying high-income taxpayers who may be offsetting their income with hobby losses do not maximize the use of all the relevant taxpayer information available to the IRS. When tax returns containing potential hobby losses are selected for audit, the examiners do not always address the hobby loss issues, according to the report.

TIGTA’s evaluation of IRS data from processing years 2011 through 2014 identified 9,699 individual returns from tax year 2013 that claimed a Schedule C loss of at least $20,000, gross receipts of $20,000 or less, and reported wages of at least $100,000. The taxpayers also reported losses in four consecutive years, for tax years 2010 to 2013. TIGTA’s review of a statistically valid sample of 100 tax returns determined that 88 of the returns showed an indication that the Schedule C businesses were not engaged in for profit. TIGTA estimates that 7,511 returns in the total sample population of taxpayers may have inappropriately used hobby loss expenses to reduce taxes by as much as $70.9 million for tax year 2013.

Section 183(a) of the Tax Code generally disallows business tax deductions for activities “not engaged in for profit” and Section 183(d), also referred to as the “hobby loss” provision, provides a presumption that most activities are engaged in for profit if the activity is profitable for three years of a consecutive five-year period (two of seven for breeding, training, showing, or racing of horses). 

A September 2007 TIGTA report found that approximately 1.2 million taxpayers in tax year 2005 may have used hobby losses to reduce their taxable incomes to potentially avoid paying $2.8 billion in taxes.  Identifying and auditing additional individual returns that improperly deduct hobby losses could help to reduce noncompliance in this area. TIGTA conducted a new audit to follow up on the 2007 report to determine whether the IRS was maximizing opportunities to identify the most significant Schedule C noncompliance.

“Taxpayers with significant amounts of income from other sources may attempt to reduce their tax liability by including losses from activities not engaged in for profit,” said TIGTA Inspector General J. Russell George in a statement. “The IRS needs to effectively identify these taxpayers in order to deter future non-compliance.”

TIGTA recommended that the IRS make use of research capabilities in its Small Business/Self-Employed Division to identify high-income individual returns with multiyear Schedule C losses and other factors that indicate the taxpayer may not have a profit or capital gain motive for the activity. The IRS should also emphasize the importance of the required filing checks in its preliminary determination of whether to pursue a hobby loss issue and provide tools to assist examiners in documenting their conclusion, the new report suggested.

In response to the report, IRS management agreed with TIGTA’s recommendations and plans to take corrective actions.

However, the IRS disagreed with TIGTA’s estimate of $70.9 million of additional tax revenue from the tax returns it sampled, given the nine criteria spelled out in under Section 183 of the Tax Code for determining whether a particular activity is engaged in for profit.

“It should be noted that the IRS, not the taxpayer, bears the burden of proving the taxpayer does not have a profit motive,” wrote Karen Schiller, commissioner of the IRS’s Small Business/Self-Employed Division, in response to the report. “Therefore, identifying returns with limited gross receipts, repetitive losses, and income from other sources, as used for your audit sample, is not sufficient to conclude that an activity was not engaged in for profit. A full examination of the individual’s books and records, addressing all nine factors outlined in the Treasury Regulations in light of the taxpayer’s specific facts and circumstances, must be conducted to draw an accurate conclusion.”

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