A new wrinkle in the hobby loss rules

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Prior to tax reform, hobby-related expenses were deductible up to the amount of income from the hobby. The expenses were miscellaneous itemized deductions and could be deducted subject to the 2 percent floor of adjusted gross income. However, the Tax Cuts and Jobs Act eliminated miscellaneous itemized deductions, with the effect that those who run an activity as a hobby rather than a business must still report income but can’t deduct expenses.

What’s more, the Tax Court recently made it clear that the hobby loss rule doesn’t apply to an activity conducted through a C corporation, noted Barbara Weltman, author of “J.K. Lasser’s Small Business Taxes 2019.”

Jeff Potter began working with his younger brother’s company, Green Country, as an independent sales representative selling potting soil and manure. Under an agreement with Green Country, Potter was treated as an independent contractor and received a commission on all sales of Green Country products to any account he either served or obtained. He incorporated Potter Sales in 1998 and was its sole shareholder, president and full-time employee. When Green Country was purchased by a competitor in 2010, Potter received a termination payment equal to 1-1/2 times his commissions from the previous year, totaling $1,729,828, plus an additional $200,000 for a covenant not to compete.

With money in the bank and free time on his hands, Potter began entering timed evens where an individual rides a horse through a designated course while shooting a firearm at targets. The rider’s firearm is loaded with primer and black powder that will shoot approximately 20 feet and make contact with balloon targets -- the embers of the powder burst the balloons.

During 2010 and 2011, Potter competed in Cowboy Mounted Shooting Association events, and successfully competed in the CMSA world competition. Potter Sales purchased a Chevrolet Silverado pickup truck for $48,000, a large horse trailer with living quarters for $104,500, and a tractor for $9,250 to be used in the activity. Potter and his wife reported the CMSA prize money as gross receipts, and reported a net profit of zero on the basis that he was paid the prize money as Potter Sales’ nominee. The Potters and Potter Sales had the same CPA prepare the returns for both years.

In its notice of deficiency, the IRS determined that the CMSA activity was not entered into for profit under Code Section 183. It disallowed all of the claimed deductions associated with the activity and included the prize winnings for each year as income to the Potters. The Potters and the IRS stipulated that all of the deductions had been properly substantiated and that if the court found that the activity was for profit then Potter Sales properly claimed the deductions. On stipulation, the Potters and the IRS restated the issue to be who performed the activity -- Potter in his individual capacity or Potter Sales as a corporation.

The Tax Court held the prize money Potter received was received as Potter Sales’ nominee.

“There is nothing to preclude Potter Sales from operating multiple trades or businesses or changing from one trade or business to another,” the court stated. “That is exactly what happened here; Potter Sales stopped selling potting soil and began operating the activity as its trade or business. The fact that Mr. Potter was the named rider in the competitions does not preclude the activity from being that of Potter Sales. The court finds that Mr. Potter received any prize winnings as Potter Sales’ nominee. Potter Sales performed the activity as a trade or business; Section 183 [the hobby loss section] does not apply.”

“The years at issue are pre-TCJA,” observed Weltman. “So the lesson for people currently is that if you have a hobby loss, you’re in a difficult position, because you have to report all the income and don’t get any deductions. But after 2025, the situation will revert to pre-TCJA law.”

“We don’t know whether the deduction would be more valuable to him or the corporation because the Tax Court’s language doesn’t give us all the information,” she said. “It’s likely that he thought the deduction would be more valuable where he claimed it.”

“The determination of a hobby activity and deductibility of related expenses depends on the tax year involved,” Weltman said. “So after 2025, hobby losses are again deductible to the extent of income from the activity.”

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