May 05, 2016

Taxpayers have no business deducting hobby losses

Hair braiding, horse racing and jet service—are they businesses engaged for profit or just hobbies? Recent Court decisions[1] in separate cases answered: business, business and hobby.

The difference in classification between business and hobby determines whether the related expenses in excess of gross income may be deducted. Taxpayers are permitted to deduct their expenses incurred in carrying on their business. But for an activity not engaged for profit—a hobby—expenses are deductible only to the extent of gross income. Tax law presumes that an activity is for profit if income exceeds deductions in at least three of the prior five years. The rule is modified to profits in two out of seven years for horse racing, horse breeding and similar activities.

If the activity fails the presumption, the Regulations list the following relevant factors to determine whether an activity is engaged for profit: (1) the manner in which the taxpayer carries on the activity, (2) the expertise of the taxpayer or his advisors, (3) the time and effort expended by the taxpayer in carrying on the activity, (4) the expectation that assets used in the activity may appreciate in value, (5) the success of the taxpayer in carrying on other similar or dissimilar activities, (6) the taxpayer's history of income or losses from the activity, (7) the amount of occasional profits, if any, earned by the taxpayer, (8) the taxpayer's financial status, and (9) elements of personal pleasure or recreation. Based on factor nine, it is not surprising that “fun” activities such as fishing, stamp collecting, photography and writing have, in many instances, been determined to be hobbies and not businesses.

In the hair braiding case, the Court ruled that the activity was a business. The Court reasoned that the taxpayer was trying to make money but the financial crisis and an over-concentration of similar businesses in the community caused the business to fail. The Court also noted that the taxpayer was not wealthy and was not using the losses to offset other income and that hair braiding was not as much fun as “riding horses.”

In the jet service case, the Court ruled that the activity was a hobby. The Court cited testimony that the taxpayer “wasn’t astute on the recordkeeping” and that the company failed to issue invoices or execute required leases. Further, the Court noted that air travel by private jet provides significant pleasures especially as compared to a commercial flight.

Unexpectedly, the horse racing activity was deemed to be a business. The Court found that all nine factors were either supportive or consistent with the claim that the activity was a business. The Court said that horse racing “may have been a fun business, but fun doesn’t convert a business to a hobby.” The Court further noted that “a business will not be turned into a hobby merely because the owner finds it pleasurable; suffering has never been made a prerequisite to deductibility.”

The message is that a fun activity can be considered a business for tax purposes provided that it is conducted in a businesslike manner and there is a true profit motive.

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.

Client alert authored by: David B. Shiner, Principal

[1] Delia v. Comr., T.C. Memo 2016-71 (April 20, 2016) (hair braiding); Roberts v. Comr., 2016 WL 1534068 (7th Cir. April 15, 2016) (horse racing); Hoffmann v. Comr., T.C. Memo 2016-69 (April 19, 2016) (jet service).