First and foremost, the IRS is suspicious right off the bat about losses generally because losses are used to offset or absorb other taxable income, thereby reducing the loss takers overall tax liability. For a rough example, let’s say every dollar of loss reported on a tax return, takes a quarter out of the IRS’ pocket.
For this reason, (and other legal reasons) taxpayers need to be very, very cautious about taking losses on their income tax returns. The Tax Code is very stingy about individual losses. For example, are you taking flow through losses from a partnership or S–corporation? Do you have a basis? Is your investment at risk? Is your loss from a passive activity?
Those are a few of the rules related to individual tax losses, which greatly limit an individual’s ability to legally take a tax loss on their income tax returns.
Along with those rules, there is another tax loss monster that lurks in the Code. It sits there waiting for its opportunity to pounce on and devour the unwary loss taker.
This monster is commonly referred to as a hobby loss –and its appetite for consuming losses is enormous.
Of course, anybody can put down anything on a tax return. And year after year these losses are claimed on returns and apparently “accepted” by the IRS, so what’s the problem?
Well, generally, the losses are only conditionally accepted. What that means is that the IRS takes a few years to get around to actually examining any particular return in detail.
A common scenario is this: A married couple earns good wage based income year after year, and takes considerable “hobby” losses year after year.
Then the audit letter arrives and they find out that their last three years of tax returns are going to be examined. They are told that their losses are now disallowed and the related tax that the losses wiped out is now due with a couple of years of penalties and interest tacked on. Then they are handed a bill demanding payment of a quiet large – or even monstrous – tax liability.
The entire problem usually starts like this:
The taxpayers have wage paying jobs or other investment income that generates a nice tax liability for the IRS. At some point these folks start type of startup business on the side.
I’ve had cases where the “startup” was car racing, horse racing, and professional fishing to name a few. The taxpayers earn significant income from their jobs or investments which, for tax purposes, are reduced dramatically by “business losses” incurred by their startup. For example, my racer earned $200K annually working a full time job, but lost $300K over about six years in his car racing business.
When he was audited, the IRS released the hobby loss monster on him and he was left with about an $80K tax bill for the three years.
So what exactly is the hobby loss monster? Well, its lair is found under Internal Revenue Code § 183.
That statute (law) says this:
Activities Not Engaged in for Profit:
General Rule – In the case of an activity engaged in by an individual or an S corporation, if such activity is not engaged in for profit, no deduction attributable to such activity shall be allowed under this chapter except as provided in this section.
Thus, with the stroke of a pen, the IRS (Congress really) has decided that no deduction – or loss – may be taken with regard to an activity that is not engaged in for profit.
That’s a fancy legalese way of saying that the IRS is not going to allow taxpayers to write off expenses related to activities they conduct, if those activities don’t, by themselves, generate taxable income.
Here’s another real life example. The taxpayer was a wage earner, but had a side business as a taxidermist. He specialized in mounting trophy fish.
As a marketing tool he entered fishing tournaments to hobnob with sports enthusiast and promote his taxidermy activity.
Those tournaments awarded cash prizes to the winners. He occasionally won tournaments. However, his expenses, such as entry fees, boat expenses, equipment and so forth far exceeded his winnings. He wrote off his expenses against his winnings, which resulted in significant losses year after year. Those losses were used to reduce his wage income, and, thus, his taxable income to the IRS.
The audit resulted in tax deficiencies for three years that were reduced at Appeals.
These are difficult cases, the IRS and even the Tax Court analyze them with extreme subjectivity. Generally, the IRS regulations provide a list of factors that are applied to the facts and circumstances of any particular case to judge whether the activity was entered into for profit.
The non-inclusive list of factors are as follows.
Manner in which the taxpayer carries on the activity: This factor supports a for profit determination where the taxpayer carries on the activity in a business-like manner and maintains complete books and records.
The expertise of the taxpayer or his advisors: This factor supports a for profit determination where the taxpayer prepares for the activity by extensive study of its accepted business, economic, and scientific practices or consults with those that are experts.
The time and effort expended by the taxpayer in carrying on the activity: This factor supports a for profit determination where the taxpayer either devotes much of his personal time to the activity, withdraws from another occupation so that his energies may be devoted to the activity or the taxpayer devotes limited time to the activity but employs competent persons to carry on the activity
Expectation that assets used in the activity may appreciate in value: This factor supports a for profit determination where the taxpayer derives a profit from the appreciation of assets, as opposed to a profit derived from operations.
The success of the taxpayer in carrying on other similar or dissimilar activities: This factor supports a for profit determination, even if the activity has been unprofitable, if the taxpayer has engaged in similar unprofitable activities in the past, which the taxpayer eventually converted to profitable activities.
The taxpayer’s history of income or losses with respect to the activity: This factor supports a for profit determination where the taxpayer takes a series of losses during the initial or start-up stage of the activity only. However, continuing losses sustained beyond a period of time that is customarily necessary to bring an operation profitable, will be indicative of an activity not engaged in for profit.
The amount of occasional profits, if any, which are earned: This factor supports a for profit determination where the taxpayer makes only an occasional substantial profit and the losses are comparatively small.
The financial status of the taxpayer: This factor supports a for profit determination when the taxpayer does not have substantial income from other sources.
Elements of personal pleasure or recreation: This factor supports a for profit determination where the activity lacks any appeal other than profit.
As you can see, these factors are both broad in scope and nebulous. Many, many experts have difficulty with these types of cases. Under no circumstances should taxpayers deal with these complex issues without counsel.
If you are having a lot of fun losing money, chances are there is a monster hiding between the lines of your tax return, just waiting for a chance to pounce.