Introduction
This article provides guidance to those concerned that their profit motivated trade or business activities remain deductible, particularly in those cases where losses have been generated in the past and/or are expected to continue to be generated in the future.
The 3-out-of-5 year rule and taxpayer misconceptions
The Internal Revenue Service (IRS) has established an administrative rule regarding their presumption of profit:
An activity is presumed to have a profit motive if it produces a profit in at least 3 of the past 5 tax years including the current year. -Publication 535: Business Expenses, IRS, p. 6.
This is merely an administrative rule used internally by the IRS. It does not have the effect of statutory law and it does not follow that an activity failing to produce a profit in at least 3 out of 5 years will be presumed to be a not-for-profit activity. Yet many taxpayers have this misconception.
No single factor constitutes evidence of profit motive, although some have evolved from case law and have been adopted by the IRS.
What is a hobby?
A hobby is an activity not engaged in for profit. The term hobby suggests an activity that is personal and recreational in nature. It is unlikely that an electrician would be concerned about having his/her business classified as a hobby. Alternatively, a skydiving instructor, who also engages in this sport for personal pleasure or recreation, may be a more likely candidate for IRS scrutiny and hobby loss classification.
10 determining factors for profit motive
10 factors are used to determine profit motive and include the following:
1. Is the activity carried on in a business-like manner?
2. Does the time and effort expended on the activity suggest profit-motive?
3. Does the taxpayer depend on the activity for his/her livelihood?
4. Are losses due to circumstances beyond taxpayer control?
5. Has the taxpayer modified operating methods to improve profitability?
6. Does the taxpayer (or advisors) possess expertise sufficient for success?
7. Has the taxpayer experienced success/profits in similar past activities?
8. Has the activity generated a profit (and how much) in past years?
9. Can the taxpayer anticipate appreciation of assets used in the activity?
10. Does the activity have elements of personal pleasure or recreation?
Evolution of the hobby loss classification
The above are factors that have evolved from tax court cases and the need to ascertain the motives of taxpayers who were self-employed and using small business losses to offset high income from other sources. This offsetting strategy results in lower taxable income and tax rates or brackets. The classic example is that of the highly compensated business executive. He wants a second home/ranch in the country, but would like to (inappropriately) deduct all or a portion of this second home in the form of interest, depreciation, stables, horses, utilities, maintenance, etc. The objective is to reduce the after-tax cost of this second residence. Losses that are excessive and unreasonable, but which offset income from other sources, are immediately suspected as recreational or hobby-related. The continuation of such unprofitable activities (when they have not proven successful in reducing losses or generating profits in the past) provides very strong evidence of the absence of profit motive. However, increasing gross profits, even when combined with increasing expenses of operation, may provide sufficient evidence of profit motive.
Credentials, publications, previous successes in similar or related activities or other evidence of expertise (or the hiring of experts) provides strong evidence of profit motive. Generally, the more time and effort put into the activity, the greater the perception and presumption of profit motive. When a taxpayer is employed in a non-related activity as well, it is useful to maintain some form of written evidence of the dates and hours spent on the activity. (Such logs need not be terribly detailed.) Dependence or reliance on income from the activity implies an absence of hobby or recreational involvement, particularly when other taxable income items (e.g., salaries) are not significantly offset.
The purchase of activity-related assets expected to appreciate implies investment. Investment expenses do not warrant the generation of allowable trade or business losses, but require capitalization or the accumulation of costs to eventually calculate the gain or loss from the investment when the sale of the asset takes place. Reclassification of the activity as investment-related will result in the disallowance of (interim) operating losses.
A checklist approach
Use the above, 10 factors, as a “hobby loss checklist” to review your exposure to hobby loss or not-for-profit classification. Generally, a “yes” response on all or most of the 10 factors contained in this article would suggest clear compliance with a factor and overall support for the evidentially supporting position of profit motive. A “no” response on a factor identifies a weakness.
Weaknesses should be pursued, if possible, to upgrade the response to an “uncertain” or “yes” response. Finally, an “uncertain” response should pursued by the taxpayer, with the objective of upgrading or strengthening the evidentiary requirements for this factor to a “yes” response. Of course, if your self-employment trade or business results in net earnings or contributes to increased taxable profits, you need not be concerned with this checklist.
Summary
These factors are only relevant to the self-employed taxpayer (1) with a tax loss from self-employment endeavors and only become critical (2) if audited by the IRS. However, to the extent practicable, all factors should be pursued with the intention of strengthening your position in the event of a loss from self-employment or an IRS audit. Taxpayers should not be dissuaded from deducting their legitimate, ordinary and necessary trade or business losses, simply out of fear of an IRS audit.