A recent taxpayer win in the Seventh Circuit Court of Appeals may be read to signal some subtle changes in the application of the hobby-loss rules under Code Sec. 183. In reversing the Tax Court, however, the appellate court nevertheless excused the Tax Court’s own application of these rules, reasoning that the Tax Court “felt itself imprisoned by a goofy regulation (Treas. Reg. Section 1.183-2: Activity Not Engaged in for Profit Defined).” Both courts tried to make sense out of the same regulation that looks to “facts and circumstances” under a nine-factor test — each arrived at a different result based upon the same facts.
The hobby-loss rules themselves may be getting a higher profile as interest in entrepreneurship takes hold within the growing ranks of the newly retired. Advertisements focus on Baby Boomers who are “not done yet,” with starting a new business cited in particular as enjoyable and fulfilling. The extent to which these Boomers will be entitled to net losses should their new “businesses” turn south may depend now, more than ever, on heeding the factors noted in the Section 183 regulations. A for-profit business can deduct expenses that exceed gross income. If the for-profit business is conducted in noncorporate form (as a sole proprietorship, limited liability company, or partnership, for example), the owner(s) of the business can use the losses to offset other income.
FACTORS UNDER THE REGS
The regulations under Code Sec. 183 describe nine non-exclusive factors to be used in evaluating whether an activity is a business. The regs advise that no one factor is decisive, that other factors should also be used … and that the factor-approach is not purely an objective test. For example, although a reasonable expectation of profit is not always required, the circumstances should indicate that the taxpayer entered into, or continued, the activity with the objective of making a profit. And in another situation that also may seem paradoxical, it may be sufficient that there is a small chance of making a large profit.
Reg. 1.183-2(b) lists, among the relevant factors to be considered, the following:
- The manner in which the taxpayer carries on the activity (businesslike or not);
- The expertise of the taxpayer or their advisors;
- The time and effort expended by the taxpayer in carrying on the activity;
- The expectation that assets used in the activity may appreciate in value;
- The success of the taxpayer in carrying on other similar or dissimilar activities;
- The taxpayer’s history of income or losses with respect to the activity;
- The amount of occasional profits;
- The financial status of the taxpayer; and,
- Elements of personal pleasure or recreation.
The courts recently issued three separate decisions that determined whether an activity was a for-profit business under Code Sec. 183. The scorecard there was two taxpayer wins and one loss. The decisions illustrate the importance of the facts and circumstances and demonstrate how the courts apply the factors in the regulations.
Horses. In Roberts, CA-7, 2016-1 USTC ¶50,260, the Seventh Circuit reversed the Tax Court’s conclusion that an individual’s racehorse activities started as a hobby and only later became a business. The taxpayer in this case was in his mid-60s and retired from a successful career in the restaurant industry. Although he incurred losses every year for the four years at issue, the appeals court found that the taxpayer conducted his activities in a business-like manner — purchasing horses, becoming a licensed trainer, building training facilities, acquiring land for larger facilities, and serving on the boards of two professional associations. The taxpayer boarded, bred, trained, cared for and raced the horses throughout the period at issue and was entitled to deduct all expenses incurred.
Although the Tax Court viewed the taxpayer’s land acquisitions in the early years as not purchased “to have a place to enjoy the golden years of his retirement,” neither did it consider the undertaking as a going business of raising horses at the time. The appeals court, on the other hand, rejected the view that the business started as a hobby. It found that the business evolved from the taxpayer’s start-up activities (his decisions to expand training facilities and to purchase land for facilities) and did not suddenly “flip” from a hobby to a business. The Tax Court’s dismissal of these earlier actions as irrelevant to the profit-making issue was clearly wrong, the appeals court concluded.
Hair salon. In Delia, TC Memo. 2016-71, Dec. 60,582(M), the Tax Court took a more lenient approach. The court concluded that the taxpayer’s hair-braiding activity qualified as a business, because the taxpayer had a genuine, if optimistic, intent to earn a profit. The taxpayer had limited resources, but leased facilities for a shop and engaged in continuous marketing efforts. The court indicated that a reasonable expectation of profit was not required, as long as the taxpayer had an actual and honest objective to make a profit. Although the taxpayer had persistent losses from the activity, she opened her salon with a genuine profit motive. While the court did allow expenses in excess of income, the court denied some expenses that the taxpayer failed to substantiate, and even imposed a negligence penalty for failure to document the expenses. In some ways, this taxpayer was lucky in not having the court view the lack of records sufficient to support certain business deductions as indicative of an un-business-like approach that lacked an underlying profit motive.
One factor in this taxpayer’s favor — a factor that is not always stated outright by case opinions — was that she did not have the deep pockets to afford losses for a period of time without some personal discomfort. For those Boomers recently retired and with an adequate nest egg to fund what might be considered more an “adventure” than a business, however, proving a profit motive may become more of a challenge.
Aircraft leasing. The taxpayer in Hoffman, TC Memo. 2016-69, Dec. 60,580(M), did not fare as well as the others. The Tax Court concluded that a taxpayer who acquired aircraft and leased them to another company he owned did not engage in the aircraft activity for profit. The taxpayer never made a profit and continued to operate the aircraft at a loss even after he could have returned the aircraft to its owner and avoided further losses by not doubling down. The court found that the taxpayer’s continued operation of the aircraft indicated a strong element of personal convenience in their continued use.
So, where does that leave the current retiree who wants to start their “dream” business that combines business with personal enjoyment — and wants to be able to offset other income if the business doesn’t show a profit?
- Assuming the retiree has a nest egg sufficient to support a start-up business that isn’t showing a profit for a while, they should also know when to “fold ‘em” — and do so, if red ink persists.
- Having an accountant or other professional advisor provide a “reality check” in evaluating whether to start a venture, and then whether to continue one, is good advice, whether or not it is aimed at being Section 183-compliant.
- Keeping good records to indicate tight business practices. Even though a retiree’s business is typically a smaller-scale operation, at least to begin with, the taxpayer should avoid the tendency to keep incomplete or confusing books and records. Good documentation is critical.
Finally, as the taxpayer in Delia learned, substantiation of a deduction must be sufficient to support a deduction under other code sections as well as Section 183. The taxpayer there lacked substantiation for some of her expenses: supplies (which were for meals), hair products, and cell phone expenses (which may have been personal in any case). These were non-deductible not because of the hobby-loss rules but because of additional substantiation rules that also were not met.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at Wolters Kluwer, Tax and Accounting US.
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