Fun or Profit ? It Matters for Hobby Loss Rules

Beware of the Hobby Loss Rules

If an individual, partnership, estate, trust, or an S corporation engages in an activity that is not conducted as a for-profit business, deductions are limited to the amount of income from the activity. If an activity is considered a for-profit business, deductions can exceed income, allowing the resulting loss to offset other income. Regulations contain a list of factors to be considered in determining whether an activity is engaged in for profit.

The factors include:

1) The manner in which the taxpayer carries on the activity,

2) The expertise of the taxpayer or his advisers,

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 with respect to the activity,

7) The amount of occasional profits, if any, which are earned,

8) The financial status of the taxpayer, and

9) Whether elements of personal pleasure or recreation are involved.

No single factor is determinative.

Court Case: The taxpayers became interested in Welsh ponies and cobs in 1995 when their daughter began riding lessons on a Welsh pony. They purchased a second horse in 1998. By 2003, they owned 10 horses. Their business plan was to acquire, breed, and train high-quality Welsh ponies and cobs and sell them.They began reporting their horse activity as a Schedule C business in 1998. After sustaining substantial losses in the activity over the next several years, the IRS disallowed the losses, claiming the activity was a hobby rather than a for-profit business.The court looked to the nine factors listed in IRS regulations to determine whether the taxpayers were engaged in a hobby or a for-profit business. For the following reasons, the court determined the manner in which the taxpayers carried on their activity, and their history of losses indicated it was not for profit.

At first, the taxpayers paid to board their horses with third-party providers. In 1999, the taxpayers concluded the horse activity could be profitable only if they purchased land and facilities where they could board their horses and generate income by providing boarding and training services to others. However, they did not begin this search until 2001, and did not actually purchase the land until 2005, on which they did not begin construction until 2006.The taxpayers continued to acquire horses in the years after 1999, increasing their stock from two horses to 10 even though they had not yet acquired land for a facility.

The court concluded that an actual and honest profit motive would have halted the purchase of new horses until after obtaining the new facility to board the horses.