Business shows a loss 5 years in a row now
I have a photographer who has had a business loss of over $15k 5 years in a row now. At what point will the IRS come back and say this is a hobby? I need to know how to advise him.
I have a photographer who has had a business loss of over $15k 5 years in a row now. At what point will the IRS come back and say this is a hobby? I need to know how to advise him.
Never seen it happen in over 30 years. I'm sure others here my have some different stories to tell.
I've seen it happen --------------- years ago, but I've seen it happen. The first question though is it really a business? Is this activity something he is actively working as a means of support, or is he working it in his spare time as a hobby?
the government seems to be pretty proficient at running deficits....... why not small business.....?
imo there is no hard rule and no one knows exactly what triggers an audit. I have a charter fishing boat captain that's been showing a loss for at least 10 years.... nothing wrong with it... he has a positive cash flow... the depreciation on the 250k boat leaves him with a loss.
They're supposed to look at what... 3 out of 5 years? I don't think I've had anyone challenged, but I'm tired of dealing with those who dabble and always have excuses. This year I've told those folks that if they are not profitable (unless they have really made some efforts and developed and followed a written business plan) that they are out of business and it will be treated as a hobby. I'm looking out for my A$$. All the preparer penalties and sanctions... It's not worth it to me.
Last year I started telling people they may not show a loss, so I have been including everything and then adding a negative deduction to bring the C to zero.
A lot depends on gross income and whether or not he has employees. A business with a high gross and/or employees is not usually questioned about the number of years it has losses.
The IRS will look at how much time he spends on it, does he advertise and can he show that he is making an effort to be profitable? Is depreciation causing the loss? Mileage? Is the loss going down each year and what is the possibility he will show a profit soon. Is it his main source of income or does he have another full time job or source of income?
I am going to give him the options, Seeing as he also has a full time job. It will be his call from there.
Here is what NATP says. There is an example of a photographer who did not have a profit motor and the ruling was against the photographer.
Hobby Loss Rules
This topic is designed to apply the knowledge of the hobby income rules
to tax planning with taxpayers. Many taxpayers have hobbies in which
they are attempting to operate as a trade or business, or better said,
want to report the loss the activity generates as a trade or business.
With heightened awareness by Congress and the IRS of taxpayers
claiming losses year after year, it becomes increasingly important to
review these rules so tax professionals can help taxpayers make
informed decisions on how to report these activities.
Upon completion of this module you will be able to:
Recall the Code and regulations governing hobby income.
Identify what the IRS and the courts have focused on when making
the determination of whether a taxpayer is engaged in the activity
Report hobby income and expenses.
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In September 2007, in a report titled Significant Challenges Exist in
Determining Whether Taxpayers With Schedule C Losses Are Engaged in
Tax Abuse, the Treasury Inspector General for Tax Administration
(TIGTA) reported to the Commissioner of the IRS that about 1.5 million
taxpayers, many with significant income from other sources, filed Form
1040 Schedule C showing no profits, only losses, over four consecutive
tax years, from 2002 to 2005. Of those, 73% were assisted by tax
professionals. Those claimed losses resulted in about 1.2 million of the
1.5 million taxpayers who potentially avoided paying $2.8 billion in
taxes in tax year 2005. TIGTA believes changes are needed to prevent
taxpayers from reducing their tax liabilities by deducting losses in notfor-
Section 183, Activities not engaged in for profit, also referred to as the
“hobby loss” provision, and related Reg. §1.183-1 do not establish
specific criteria for the IRS to use in determining whether a Schedule C
loss is a legitimate business loss without conducting a full examination
of an individual’s books and records. The purpose of the hobby loss
provision was to limit the ability of wealthy individuals with multiple
sources of income to apply losses incurred in “side-line” diversions to
reduce their overall tax liabilities. TIGTA’s analysis showed 332,615
high-income taxpayers received the greatest benefit by potentially
avoiding approximately $1.9 billion in taxes for tax year 2005.
The Internal Revenue Code and treasury regulation do not require a
taxpayer to have a reasonable expectation of profit; rather, the
taxpayer simply needs the “objective” of making a profit.
TIGTA conducted this audit because the IRS estimates incorrect
deductions of hobby expenses account for a portion of the overstated
adjustments, deductions, exemptions, and credits that result in about
$30 billion per year in unpaid taxes.
TIGTA recommended that the Commissioner of Small Business/ Self-
Employed Division, provide a copy of this report to the Department of
the Treasury, Office of the Assistant Secretary for Tax Policy, to
consider proposing legislative changes to §183. The proposal would
include establishing a clearly defined standard or bright-line rule for
determining whether an activity is a business or a not-for-profit activity.
Due to the large number of these tax returns being prepared by tax
practitioners, TIGTA also recommended the Director of
Communications, Liaison, and Disclosure, Small Business/Self-Employed
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Division, continue to coordinate with practitioner organizations to
encourage compliance with existing provisions.
In their response to the report, IRS officials stated they agreed with the
recommendations and plan to take appropriate corrective actions. The
Director of Communications, Liaison, and Disclosure, Small
Business/Self-Employed Division, plans to coordinate with the Office of
Legislative Affairs to forward a copy of the final report to the
Department of the Treasury Office of Tax Policy and to include key
messages and talking points about §183 tax obligations as a fiscal year
2008 outreach initiative directed to practitioner organizations.
Note: To date, there have been no legislative changes to §183.
The IRS has created a fact sheet in 2008 and an Audit
Technique Guide in 2009.
Outreach to Taxpayers
The IRS issued Fact Sheet 2008-23, as an outreach to taxpayers, titled
Is Your Hobby a For-Profit Endeavor? In the spirit of the nine factors in
Reg. §1.183-2(b), the IRS compiled a list of questions the taxpayer
should ask himself or herself as to whether an activity is engaged in for
profit or a hobby:
Does the time and effort put into the activity indicate an intention to
make a profit?
Do you depend on the income from the activity?
If there are losses, are they due to circumstances beyond your
control or did they occur in the start-up phase of the business?
Have you changed methods of operation to improve profitability?
Do you have the knowledge needed to carry on the activity as a
Have you made a profit in similar activities in the past?
Does the activity make a profit in some years?
Do you expect to make a profit in the future from the appreciation of
assets used in the activity?
Most notably missing from the nine relevant factors in Reg. §1.183-2(b)
is the element of personal pleasure or recreation involved in the
activity. The nine factors are reviewed in further detail later.
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In June 2009, the IRS released the Audit Technique Guide (ATG) titled
IRC §183: Activities Not Engaged in For Profit (ATG). This guide is
extremely insightful. It can be read as a “how-to guide” for taxpayers in
operating a trade or business.
The ATG gives examples of possible §183 activities: fishing, farming,
craft sales, dog breeding, gambling, direct sales, entertainers, horse
racing, horse breeding, motocross racing, auto racing, bowling, yacht
charter, photography, airplane charter, stamp collecting, artists,
writing, and rentals.
In the ATG, the IRS has return preparer penalties listed in addition to
the taxpayer penalties. The IRS indicates that the vast majority of
return preparers and practitioners are ethical, honest, and serve their
client’s best interest by preparing complete and accurate tax returns.
However, taxpayers are sometimes advised by preparers to claim
activities that are not engaged in for profit or are a sham. The primary
purpose of return preparer penalties is to bring noncompliant tax return
preparers into compliance. When focusing on preparer conduct, not
taxpayer conduct, examiners are told to consider preparer penalties
Deductions are claimed that are not ordinary and necessary
expenses incurred in carrying on a trade or business.
Attempts are made to characterize personal expenses as business
Note: The ATG has helpful insights into the IRS’s thinking.
For a copy of this or any other ATG, go to
Congress created §183, Activities not engaged in for profit, specifically
to help a taxpayer determine if he or she has hobby income. Hobby
income can be generated by an individual, a partnership, S corporation,
estate, or a trust, but not a C corporation.
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The term “activity not engaged in for profit” means any activity other
than one with respect to which deductions are allowable for the taxable
year under §162 or under §§212(1) and (2) [§183(c)]. An activity not
engaged in for profit is defined by what it is not; it is not an activity in
which deductions are allowed for all the ordinary and necessary
expenses paid or incurred during the tax year:
In carrying on a trade or business.
For the production or collection of income.
For the management, conservation, or maintenance of property held
for the production of income.
Because §183(c) only lists §§162 and 212, that leaves room for §174,
Research and developmental expenditures. In TC Memo 1994-523, the
Tax Court found §§162 and 212 to have somewhat different threshold
standards for deductibility than §174. During the years under
consideration, the taxpayer in that case was engaged in the early
stages of product development, and no sales had been attempted or
had occurred; therefore, The Tax Court concluded that all of the
taxpayer's activity should be judged under the requirements of §174.
Section 174(a)(1) allows a taxpayer to currently deduct research and
experimental expenditures paid or incurred in connection with the
taxpayer's trade or business. The Supreme Court has held that research
and development costs may be deductible under §174, even though
there was no product for sale in the year(s) the deductions were
claimed [Snow v. Commissioner, 416 U.S. 500 [33 AFTR2d 74-1251]
The Tax Court concluded that, to be entitled to a deduction under §174,
the taxpayer must be engaged in a trade or business at some time, and
its activities must be sufficiently substantial and regular to constitute a
trade or business [Green v. Commissioner, 83 T.C. 667, (1984)].
Section 183(d) has a presumption, a safe harbor, used to make the
determination without difficulty. The presumption is, if an activity
produces a profit in three out of five years, generally the activity is
considered a trade or business and is reported on the business return
(i.e., for individuals this would be Schedule C, E, or F). If the activity is
for horse breeding, racing, training, or showing, it must make a profit in
two out of seven years. If the taxpayer’s activity does not meet this
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presumption, then the nine relevant factors are used from the
regulation to make the determination.
Nine Relevant Factors
Reg. §1.183-2 lists nine relevant factors to use in determining whether
an activity is engaged in for profit. These factors are helpful if the
taxpayer wants to assert an activity is engaged in for profit but does not
meet the safe harbor presumption of a trade or business under
In determining whether an activity is engaged in for profit, all facts and
circumstances with respect to the activity are taken into account, not
just the nine factors listed in the regulation. No one factor is primary in
making this determination. In addition, it is not intended that only these
factors are taken into account in making the determination, or that a
determination is made on the basis that the number of factors (whether
or not listed in the regulation) indicating a lack of profit objective
exceeds the number of factors indicating a profit objective, or vice versa
Manner of Carrying on the Activity
The fact that the taxpayer carries on the activity in a businesslike
manner and maintains complete and accurate books and records
indicates that the activity is engaged in for profit. Similarly, where an
activity is carried on in a manner substantially similar to other activities
of the same nature that are profitable, a profit motive is indicated. A
change of operating methods, adoption of new techniques, or
abandonment of unprofitable methods in a manner consistent with an
intent to improve profitability also indicates a profit motive [Reg.
Books and Records
In the ATG, the first thing mentioned for this section of the regulation is
the books and records of the taxpayer. Although having sophisticated
books and records may seem impressive, the examiner is advised this
does not automatically equate to the taxpayer having a profit motive.
2009 NATP Beyond the 1040 81
Books and records should be kept in such a way that the taxpayer can
rely on to operate the activity and make decisions and changes. The
examiner is advised to document how the books and records are utilized
by the taxpayer.
Even though sophisticated books and records do not necessarily equate
to having a profit motive, having a shoe box system with no rhyme or
reason is trouble. The taxpayer should be advised to establish some
form of organized books and records that will help him or her operate
the activity and make decisions and changes when and if needed. A
separate checking account should be used to handle all items of income
The taxpayer should have a formal written business plan. Taxpayers
who do not have a written business plan often have created one in their
mind. By having the taxpayer put these ideas down in a formal written
business plan, the taxpayer may find this process beneficial. In the
ATG, examiners are advised not to ask for the business plan in the first
meeting because he or she may receive a “canned” document. The
examiner is advised to inquire about the business plan during the initial
interview and then to follow-up with a subsequent appointment.
The plan should be realistic and provide short range and long range
forecasts of the activity. The plan should allow for changes due to
things that can be reasonably expected and unexpected circumstances.
The examiner will perform quantitative analyses to determine the
reasonableness of the projected gross receipts and expense items. The
examiner has the availability to consult with IRS economists to review
the business plan.
By having the business plan in writing, the taxpayer can show whether
or not the plan was followed and, if the original plan was not successful,
whether the taxpayer made changes to the plan to increase profitability.
The books and records present the numbers. The formal business plan
presents the ideas and methods in writing. Operating the business is
where the tire hits the road. The regulation states it quite clearly when
it says a change of operating methods, adoption of new techniques, or
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abandonment of unprofitable methods in a manner consistent with an
intent to improve profitability also indicates a profit motive. In the ATG,
the examiner is advised to take note whether the taxpayer is making
changes to the operations that will result in improved operational
If customers do not know of the taxpayer’s product or service, the
taxpayer cannot expect profitability. Advertising is important. The ATG
has these questions for the examiner to ask about advertising or
promotion during the interview:
What advertising and promotion activity did the taxpayer perform to
What other relationship did the taxpayer have with his
What forms of advertising have been used? How often? How much?
How effective was the advertising? Have ineffective methods been
Expertise of the Taxpayer or Advisors
Preparation for the activity by extensive study of its accepted business,
economic, and scientific practices, or consultation with those who are
expert therein, indicates that the taxpayer has a profit motive where
the taxpayer carries on the activity in accordance with such practices.
Where a taxpayer has such preparation or procures such as expert
advice, but does not carry on the activity in accordance with such
practices, a lack of intent to derive profit is indicated, unless it appears
that the taxpayer is attempting to develop new or superior techniques
that may result in profits from the activity [Reg. §1.183-2(b)(2)].
The questions in the ATG provide insight into this factor:
What background information was gathered about this type of
activity prior to beginning the business?
Has the taxpayer ever been employed in this area before?
When, where, for whom, how long, and what experience
specifically pertains to this activity?
Does the taxpayer have any education that is relevant?
Degree, classes, how does it apply to this business or how did it
prepare the taxpayer in any way to enter this field of business?
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Does the education relate to any other business or employment
Did the taxpayer rely on the advice of others in starting or
developing the business?
Did the taxpayer consult with experts?
What are the credentials of others in starting or developing the
What experience, education, degrees, business success do they
possess that qualify them to advise the taxpayer.
How did the taxpayer decide to rely on the person’s advice?
Was there any kind of previous personal, family, or business
relationship with the advisor?
Did the taxpayer prepare for the activity by conducting research or
an extensive study of its accepted business, economic, and scientific
What types of journals, publications, or other reference material
did the taxpayer study in preparation to enter this business?
What did the taxpayer learn that entered into the decision to
engage in this business activity?
What professional publications does the taxpayer now subscribe
to and what specific benefit does the taxpayer derive?
What other life experiences does the taxpayer have that would have
prepared the taxpayer to engage in this type of activity?
What related organizations does the taxpayer belong to? How long?
Time and Effort Expended in the Activity
The fact that the taxpayer devotes much of his or her personal time and
effort to carrying on an activity, particularly if the activity does not have
substantial personal or recreational aspects, indicates an intention to
derive a profit. A taxpayer’s withdrawal from another occupation to
devote most of his or her energies to the activity is also evidence that
the activity is engaged in for profit. The fact that the taxpayer devotes a
limited amount of time to an activity does not necessarily indicate a lack
of profit motive where the taxpayer employs competent and qualified
persons to carry on such activity [Reg. §1.183-2(b)(3)].
This factor is self explanatory. The ATG alerts the examiner of an
alternate position under §469. The time others spent in the activity is to
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be documented in relation to the taxpayer’s time spent with regard to
this potentially being a passive activity, thereby limiting passive losses.
Expectation That Assets Appreciate
The term “profit” encompasses appreciation in the value of assets, such
as land, used in the activity. Thus, the taxpayer may intend to derive a
profit from the operation of the activity, and may also intend that, even
if no profit from current operations is derived, an overall profit will
result when appreciation in the value of land used in the activity is
realized, since income from the activity, together with the appreciation
of land, will exceed expenses of operation [Reg. §1.183-2(b)(4)].
The IRS confesses in the ATG this factor is the most difficult of the nine
relevant factors for examiners to correctly develop. Taxpayers have
generally been successful with this factor because of the potential for
land appreciation. So, the angle an examiner is to attempt to develop is
whether the operation of the taxpayer’s activity and the holding of the
land are considered to be a separate or single activity.
As a single activity, the taxpayer is allowed to use the appreciation in
the value of the asset to determine if there is an overall profit from the
activity. If the operation of the activity and the holding of the assets are
considered two separate activities, the history of operational losses
cannot be offset by the potential gain from the asset appreciation.
In order to show that the operation of the activity and the holding of the
assets should be treated as separate activities, the examiner is told to
prepare an analysis showing the history of the activity. Beginning with
gross receipts, the examiner needs to separate current operating
expenses from the costs of carrying the assets. These carrying costs
include depreciation, property taxes, and related interest expense. To
accomplish this, a spreadsheet can be created totaling the carrying
Do gross receipts exceed current operating expenses with a resulting
net profit? If gross receipts do not exceed current operating expenses,
the operation of the activity and the holding of the assets are
considered two separate activities. As two separate activities, the
history of losses cannot be offset by the future potential gain (i.e., the
appreciation of the assets).
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Success in Carrying on Other Activities
The fact that the taxpayer has engaged in similar activities in the past
and converted them from unprofitable to profitable enterprises indicates
that he is engaged in the present activity for profit, even though the
activity is presently unprofitable [Reg. §1.183-2(b)(5)].
This one is the simplest to comprehend, yet it is not one of the most
History of Income or Losses
A series of losses during the initial or start-up stage of an activity is not
necessarily an indication that the activity is not engaged in for profit.
However, where losses continue to be sustained beyond the period that
customarily is necessary to bring the operation to profitable status,
such continued losses, if not explainable as due to customary business
risks or reverses, is indicative that the activity is not being engaged in
for profit. If losses are sustained because of unforeseen or fortuitous
circumstances that are beyond the control of the taxpayer, such as
drought, disease, fire, theft, weather damages, other involuntary
conversions, or depressed market conditions, such losses are not an
indication that the activity is not engaged in for profit. A series of years
in which net income was realized is strong evidence that the activity is
engaged in for profit [Reg. §1.183-2(b)(6)].
Courts have expressed that losses during the initial or start-up stages of
an activity are common and they do not necessarily point to a lack of
profit objective. If there are losses past this stage, is there an
explanation for them? What has the taxpayer done to change the
method of operation to lessen or eliminate future losses? Have the
losses increased from year to year?
With the idea that books and records are maintained in such a way that
the taxpayer can rely on them to operate the activity and make
decisions and changes, the tax return can also be reviewed to show
categories of expenses as part of the decision making process.
Preparing a year by year summary of the income and expenses on a
spreadsheet helps in analyzing the trends from year to year for each
item listed on the spreadsheet.
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Amount of Occasional Profits
The amount of profits in relation to the amount of losses incurred, and
in relation to the amount of the taxpayer’s investment and the value of
the assets used in the activity, provides useful criteria in determining
the taxpayer’s intent. An occasional small profit from an activity
generating large losses, or from an activity in which the taxpayer has
made a large investment, is not generally determinative that the
activity is engaged in for profit. However, substantial profits, though
only occasional, are indicative that an activity is engaged in for profit,
where the investment or losses are comparatively small. Moreover, an
opportunity to earn a substantial ultimate profit in a highly speculative
venture is ordinarily sufficient to indicate that the activity is engaged in
for profit even though losses or only occasional small profits are actually
generated [Reg. §1.183-2(b)(7)].
From the analysis done for the history of income and losses, the
taxpayer’s investments over those years can be added to see if he or
she is either meeting or failing this factor.
Financial Status of the Taxpayer
The fact that the taxpayer does not have substantial income or capital
from sources other than the activity indicates that an activity is
engaged in for profit. Substantial income from sources other than the
activity (particularly if the losses from the activity generate substantial
tax benefits) indicate that the activity is not engaged in for profit
especially if there are personal or recreational elements involved [Reg.
Taxpayers with other substantial sources of income, who also benefit
from the losses generated from the activity in question, may continue
to engage in an activity that remains unprofitable, when taxpayers
without other substantial sources of income would have discontinued
because of its unprofitability.
A tax benefit analysis should be done to either prove or disprove this
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Elements of Personal Pleasure or Recreation
The presence of personal motives in carrying on of an activity indicates
that the activity is not engaged in for profit, especially where there are
recreational or personal elements involved. On the other hand, a profit
motive is indicated where an activity lacks any appeal other than profit.
It is not, however, necessary that an activity be engaged in with the
exclusive intention of deriving a profit or with the intention of
maximizing profits. For example, the availability of other investments
that would yield a higher return, or that would be more likely to be
profitable, is not evidence that an activity is not engaged in for profit.
An activity is not treated as “not engaged in for profit” merely because
the taxpayer has purposes or motivations other than solely to make a
profit. The fact that the taxpayer derives personal pleasure from
engaging in the activity is not sufficient to cause the activity to be
classified as not engaged in for profit if the activity is in fact engaged in
for profit as evidenced by other factors, whether or not listed in this
paragraph [Reg. §1.183-2(b)(9)].
This is not trying to put a damper on a person who enjoys his or her
work. What this last factor is addressing is the whole reason why the
§183 limitation of losses from activities not engaged in for profit got its
nickname “hobby losses.” A taxpayer cannot engage in a hobby that he
or she would continue to do regardless of profit motive and report tax
losses each year.
If a taxpayer does not have this factor in his or her favor, then the
focus must be on meeting the other factors.
Do not overlook the potential enjoyment or recreation of the activity
from members of the taxpayer’s family, or by his or her friends.
REQUEST TO POSTPONE DETERMINATION
Form 5213, Election to Postpone Determination as to Whether the
Presumption Applies that an Activity is Engaged in for Profit, is available
for a taxpayer’s election to delay the safe harbor determination until the
close of the fourth year (for horse racing, breeding, or showing until the
Filing Form 5213 automatically extends the statute of limitations for
assessing any income tax deficiency specifically attributable to the
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activity during any year in the presumption period. If the taxpayer
elects a postponement, the statutory period is extended two years after
the due date (without extensions) for filing the return for the last
taxable year in the five or seven year presumption period [§183(e)(4)].
Example: Nick operates a farming activity. Nick files Form 5213 for
the 5-year presumption period that began in 2004 and ends in 2008.
The period of limitations automatically extends to April 15, 2011, for
all tax years in the presumption period.
The automatic extension applies only to those deductions attributable to
the activity and to any deductions that are affected by changes in AGI
(i.e., medical expenses or charitable contribution deductions). It does
not extend the statute of limitations for issues not related to any §183
As a practical matter, requesting postponement of the safe harbor
determination is rarely used unless the taxpayer has been notified by
the IRS of a proposed disallowance of the deductions reported in a
potential hobby activity.
FOCUS BY THE IRS AND COURTS
The focus by the IRS and courts are the relevant factors in Reg.
§1.183-2(b). The taxpayer should be advised to focus on those as well.
The first factor listed in the regulation involves the manner in carrying
on the activity. The regulation says no one factor is primary in making a
determination, yet operating in a business-like manner is highly
important and something a tax professional can coach the taxpayer on
doing (i.e., business checking account, proper receipts for business
expenditures that are separated from personal expenditures, etc.).
Furthermore, the taxpayer’s willingness to change the method of
operation in attempts to increase profitability has been noted in many
cases ruling in favor of the taxpayer.
The IRS will narrow its focus to any relevant factors proving a lack of
profit objective in building a case against the taxpayer. The taxpayer
2009 NATP Beyond the 1040 89
should continue to strengthen the relevant factors in his or her favor
and be able to provide documented evidence. Furthermore, the
taxpayer can strive to improve on those relevant factors that are not in
his or her favor. When and if it is time for the courts to review, the
courts look at both the relevant factors in favor of the taxpayer and
those not in favor of the taxpayer.
Analysis of Cases
Presented next are two court cases involving situations where the court
determined one activity by the taxpayer was not engaged in for profit
and the other activity by the same taxpayer was deemed to be engaged
in for profit. The third court case is just a quick summary of a common
activity not engaged in for profit, an Amway products distributorship.
Parasailing and Photography
In TC Memo 1991-383, Mark and Carol had two activities the Tax Court
was asked to review: parasailing and photography.
With regard to the parasailing activity, Mark and Carol took special
classes, conducted the activity in a business-like manner, advertised,
and examined ways to increase riders and profits. They discontinued
the activity only after failing to find adequate liability insurance at a
reasonable cost. The Tax Court allowed a loss deduction for the
parasailing activity because it found the activity to be engaged in for
Mark and Carol convinced the Tax Court of a profit objective because,
among other things, the activity was operated in a business-like
Supporting this conclusion, the Tax Court identified these facts:
The activity operated on days and at times when there was a
demand for the products and services it offered.
Mark and Carol sought out and obtained the training and experience
necessary to properly operate the business.
They consulted with persons familiar with the business for advice and
counsel, both before organizing the company and concurrent with its
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The business was promoted through the use of printed business
cards, advertisements in the yellow pages, and by display
advertising to promote rides.
Mark and Carol inquired about and determined what the legal
requirements were for operating a commercial enterprise on the
lakes near their home, and applied for the license they thought was
necessary for the company to meet such requirements.
The company obtained a sales tax license and reported and collected
sales tax on the items sold.
The company used a written contract with its customers in an
attempt to protect itself from the increased risk of liability faced by a
Mark and Carol maintained an accounting system to record the
receipts and disbursements of the business.
The Tax Court indicated that all of these factors show Mark and Carol
regarded their parasailing activity as a business and were seriously
trying to make a profit in operating it.
However, the IRS argued that it was unreasonable for Mark and Carol to
believe that they could profit from a parasailing enterprise in the San
Antonio, Texas, area because of the limited summer season they could
sell their products and services. The Tax Court found the IRS failed to
adequately explain this conclusion (Note: if they could have explained
and convinced the Court, this would be a very important factor).
Furthermore, the IRS argues that parasailing was more like a hobby
because Mark and Carol loved water sports and were avid boaters and
water skiers. The Tax Court indicated that a business need not be called
a hobby merely because the owners find it pleasurable. Even if Mark
and Carol started parasailing because of their interest in that sport,
they soon perceived the profit potential in selling the necessary
equipment and in providing rides to others for compensation. Someone
who pursues parasailing as a hobby would not regularly interrupt his or
her participation in the sport to take the time to entice others to
participate, nor charge them to participate, especially on a regular
basis. These actions indicate that Mark and Carol were trying to
generate income, not just enjoying themselves on a lazy summer
With regard to the photography activity, a loss deduction was denied for
lack of profit motive. The Tax Court found the objective facts regarding
Mark’s photographic activity lead them to conclude he did not engage in
it with an object of making a profit. Details of the photography activity
2009 NATP Beyond the 1040 91
were that Mark acquired his equipment over an extended period of
time, and took the photographs he offered for sale while he was on
personal trips. His promotional efforts were minimal and he only sold
photographs incidentally in connection with his ordinary course of
employment of selling office supplies. Nothing in the record showed an
attempt on Mark’s part to acquire the expertise to distinguish him from
an amateur photographer who would be highly interested in
photography. Mark received no formal or informal training in the art of
photography from professionals or contemporaries in the business. He
did not actively seek out and adopt business techniques in the
photography activity as he and Carol had done in the parasailing
In TC Memo 1991-123, Paul was allowed to claim expenses in
proportion to his profit share for supporting his son’s auto racing
activity. The son sought expert advice and vigorously attempted to
obtain a sponsor, and he was believed to have engaged in auto racing
for profit. Paul was not allowed expenses in excess of gross income for
his own auto racing activity. Even though Paul researched the activity,
maintained records, and sought expert advice, he incurred substantial
losses, competed for a short time, and only made sporadic attempts to
procure a sponsor.
Paul is an attorney and many years prior to engaging in the auto racing
activities, he practiced law. He and a partner formed a real estate
development and sales business that was relatively successful, giving
him compensation in excess of $200,000 for all the years at issue.
Note: What Paul had done in the past as well as what he is
successfully doing currently would be helpful to Paul’s
position if it were similar activities to what he is
attempting to do now. Also, obtaining substantial sources
of income from other activities is indicative of a lack of
profit motive especially if there are personal or
recreational elements involved.
92 2009 NATP Beyond the 1040
In 1973, Paul opened a checking account in the name of Paul Dwyer
Enterprises (Dwyer Enterprises) to handle business investments. In
1979, Paul met with Mike Bonicelli, a race car driver who was the
Colorado Springs International Speedway (CSIS) 1979 track champion.
Paul, his son Clark, and Bonicelli met and discussed NASCAR racing,
driving, and financial aspects of auto racing.
Note: Consulting with Bonicelli fits in with the factor of
obtaining expert advice.
In January 1980, when Paul and his son began conducting auto racing,
it was under the newly formed Dwyer Enterprises Racing Division that
he claimed the auto racing expenses for himself and his son.
In August 1980, Dwyer Enterprises sent a race team, with Clark as the
driver, to race at Bakersfield, California. Clark won the 35-lap main
event. He received $1,500, which the court found particularly
noteworthy because Clark was only 16 years old and had never driven a
race car before 1980. In the fall of 1980, Clark began his junior year of
high school. After several conversations with the school, Clark’s parents
agreed to permit Clark to leave school to pursue racing. In October
1980, Clark took 5th place in the CSIS Grand Finale Budweiser 200.
During 1980, Paul drove in 22 racing events and Clark drove in
approximately 22 to 28 events. At the conclusion of the 1980 racing
season, Paul and Clark reviewed their results and made racing plans for
the ensuing year. They decided to upgrade their racing cars and
equipment, and to increase their efforts to get sponsorships.
During 1981, Paul drove in approximately 15 racing events and Clark
drove in approximately 25 events. At the end of the 1981 racing
season, Paul and Clark reviewed the results of their racing activities.
Paul decided to quit racing because he was not sufficiently skilled to
make a profit wherein Clark would have to race at the Winston Cup
level to be profitable.
2009 NATP Beyond the 1040 93
Note: A change in operating method is an essential factor. The
case provides numerous examples of Paul’s and Clark’s
willingness to abandon unprofitable methods with the
attempt to increase profitability.
Beginning in 1982, two employees were hired to provide full-time
professional help in assisting Clark in preparing and maintaining the
race cars. Paul regularly attended Clark’s races and often worked as a
team spotter. Paul created the Dwyer Enterprises “race pack” that
consisted of time sheets, Paul’s race notes regarding lap times and
track peculiarities, race rules, entry forms, and lists showing purses and
awards. There were three accidents in 1982, two of which Clark was
doing well before the accident, thereby losing the possibility of any
purse money in those races.
In the fall of 1982, Paul and Clark were introduced to Roger Hamby, a
former racecar driver, and at that time, an independent NASCAR Grand
National car owner. Paul entered into an agreement with Hamby for
Clark to run five races on the NASCAR Winston Cup Circuit in 1983
driving Hamby’s car on a turnkey flat charge basis. The cost to Paul was
$12,000 per race and Hamby would retain all winnings. Then, in 1984,
Dwyer Enterprises would run Clark for Rookie of the Year in all the
NASCAR Grand National races. Clark moved to Charlotte, North
Carolina, to work with Hamby on his team during the other 1983
NASCAR races in order to learn the tracks and improve his driving skills.
Paul believed that by success in Winston Cup races, Clark could get a
sponsor, and a new approach of buying rides would be a less expensive
way to race than continuing to own and operate a complete race team.
Regardless of Clark’s performance, there was little chance for Paul to
break even in 1983 from the racing activities without a sponsor because
they were not entitled to any race winnings for the five races Clark was
under agreement to run.
In 1984, Dwyer Enterprises again negotiated with Hamby to purchase
rides and run Clark for Rookie of the Year. Of the races Clark drove in
1984, he did not finish any higher than 15th place. He ended up 4th in
the Rookie of the Year contest and 23rd in the final Winston Cup point
In 1985, under a turnkey agreement with Elmo Langley, Clark was to
ride the entire season, 28 races, on the Winston Cup Circuit for a fee of
$100,000, 80% of any car winnings, and all advertising and race bonus
94 2009 NATP Beyond the 1040
money. Of the 28 races Clark drove in 1985, he did not finish any
higher than 14th place. He finished 22nd in the overall Winston Cup
In 1986, Dwyer Enterprises and Buddy Arrington agreed that Clark
would drive one of Arrington’s cars in the Daytona 500; in exchange
Arrington was paid $10,000 plus two-thirds of all purse money. Dwyer
Enterprises was entitled to use the rear quarter panels, hood, and rear
deck lid for advertising and could retain any sponsor advertising it could
sell. Dwyer Enterprises negotiated agreements for an $8,000
sponsorship in the Daytona 500 with Skip’s Boot Barn and a $5,000
sponsorship with Dunhill Investments, Ltd. Dwyer Enterprises failed to
make the Daytona 500 field when Clark, driving Arrington’s car,
qualified 41st in the 40-car field. Since Dwyer Enterprises failed to
make the Daytona race, its advertising agreements were never
Clark did not participate in any further races in 1986. For the rest of
1986, Dwyer Enterprises limited its racing activities to searching for a
sponsor or a driving position for Clark that did not require payment of a
ride fee. Dwyer Enterprises was advised by a manager of the Charlotte
Motor Speedway to go back to short track racing and try to win some
The promotional activity during these years was extensive. Paul sought
expert help from his accountant as to what books and records he would
need to establish a NASCAR racing business. His accountant was
particularly qualified in this regard because he had previously given
accounting and business advice to others involved in several
Clark derived satisfaction and public recognition from racing but he also
worked long hours at the shop and hard, dirty, physical work on the
The Court’s analysis of Paul’s auto racing activity in 1980 and 1981
found that there are several factors indicating that the petitioner carried
on his racing activity in a businesslike manner:
Paul operated the racing activity under the name Dwyer Enterprises.
He discussed with his accountant the accounting, financial, and tax
aspects of the proposed NASCAR racing business, and maintained a
separate bank account for Dwyer Enterprises.
Paul kept records of his expenses included for his racing activity.
He investigated the NASCAR racing business prior to embarking on
the racing venture.
2009 NATP Beyond the 1040 95
Paul consulted with and followed the advice of a number of racing
However, there was more evidence showing that Paul lacked the
requisite profit objective. During 1980 and 1981 Paul incurred
substantial losses from his auto racing activity. He did not compete long
enough to enable him to potentially make a profit. Throughout that time
he had a full-time job that demanded much of his attention.
Furthermore, Paul earned sufficient income from his real estate
business to enable him to pursue auto racing. His efforts to secure
sponsorship were sporadic and he won no meaningful prize money.
Even though it is not conclusive, a record of substantial losses over the
years and the unlikelihood of achieving a profitable operation are
important factors bearing on the taxpayer’s true objective. Paul derived
personal pleasure from auto racing. The Court did not believe that
business and pleasure are mutually exclusive; however, in Paul’s case it
appeared that he engaged in the racing activities as a form of
The Court concluded, after examining the facts of the case, that there
were business aspects of Paul’s racing but that it was an activity
engaged in not for profit.
The Court’s analysis of Paul’s support for Clark’s auto racing activity
from 1980 to 1986 showed the history of Clark’s racing activity was
consistent with an objective to make a profit:
Paul and Clark attended the Southards School of High Performance
Circle Track Racing before participating in any races.
Throughout Clark’s racing activities, Paul consulted with and followed
the advice of a number of experienced NASCAR racing people in
order to increase Dwyer Enterprises’ opportunity to achieve financial
Dwyer Enterprises showed flexibility by changing its operating
methods, trying new approaches, and discontinuing those methods
that did not work. A change of operating methods or abandonment
of unprofitable methods in a manner consistent with the intent to
improve profitability may indicate a profit objective.
Dwyer Enterprises carried on its NASCAR activities in a business-like
manner and maintained adequate books and records.
The many hours spent obtaining sponsorship for Clark was similar to
the activities of drivers who ultimately did obtain a sponsor.
96 2009 NATP Beyond the 1040
In Clark’s case, the only thing against Paul was the significant losses.
The Court indicated that the presence of losses in the formative year of
a business is not inconsistent with an intention to achieve a later
profitable level of operation. Of the $166,422 loss in 1981, $60,000 was
due to theft, which was unexpected and beyond the control of Dwyer
Enterprises. A portion of the 1982 loss resulted from three car wrecks;
two of them happening in a late stage of the race that Clark was doing
well in prior to the wreck. Dwyer Enterprises’ losses were incurred in
the start-up of a very competitive business that few succeed. The losses
were not sustained for a period beyond what is customarily necessary
for a NASCAR racing operation to achieve profitable status.
Paul was found to have entered the NASCAR racing business in 1980
believing that Clark would be a successful driver and that he could
make a profit from Clark’s racing. Paul’s sponsorship of Clark’s auto
racing during 1980 through 1986 was an activity engaged in for profit.
Paul was allowed 53% of his expenses relating to Clark’s auto racing
activity in 1980 and 62% of expenses in 1981. The percentages were in
proportion to Paul’s profit share of the activity.
In TC Memo 2003-142, an engineer and his wife were not entitled to
business deductions for the expenses they incurred in connection with
their Amway products distribution activity. The taxpayers had no
business plan, did not analyze the potential market, or determine what
level of sales would be necessary to become profitable. They had no
experience in business and only looked to insiders for advice. They
ignored their accountant’s negative advice. They sold products at cost
and relied solely on unrealistic strategy of recruiting new distributors as
a way to make a profit. They never restrategized after years of losses.
The Tax Court found this distribution activity was used to socialize with
friends and family (i.e., the engineer and his wife recruited downline
distributors largely from among their friends and family).
The engineer and his wife appealed. The U.S. Court of Appeals, Fifth
Circuit, found that the Tax Court properly determined that they were
not entitled to business expense deductions in connection with their
Amway products distribution activity. Although the taxpayers showed
proof of profit motive, it was not sufficient enough to override the IRS’
evidence that included their failure to keep business-like records, failure
to alter unprofitable methods, their nondependence on the income from
the activity, and use of the activity to socialize with friends and family.
2009 NATP Beyond the 1040 97
The earlier Tax Court proceeding accepted the IRS’s incorrect
calculation of their gross receipts from the activity. The IRS now
conceded that this calculation was incorrect because it did not subtract
the cost of goods sold from gross receipts in determining the taxpayers’
gross income (Lopez v. Comm., Cite as 94 AFTR 2d 2004-7075).
REPORTING HOBBY INCOME AND EXPENSES
Hobby income can be generated by the individual, a partnership,
S corporation, estate, or a trust. The reporting by each entity does have
some differences, but mostly they have similarities.
If the activity is deemed a hobby, the income is reported on Line 21 of
Form 1040 and the expenses of the hobby cannot exceed the income.
The amount reportable as income on Line 21 is referred to as gross
income. Reg. 1.183-1(e) explains that gross income derived from an
activity not engaged in for profit includes the total of all gains from the
sale, exchange, or other disposition of property, and all other gross
receipts derived from such activity. Such gross income includes capital
gains and rents received for the use of property that is held in
connection with the activity. The taxpayer may determine gross income
from any activity by subtracting the cost of goods sold from the gross
receipts, so long as he consistently does so, and follows generally
accepted methods of accounting in determining such gross income.
Example: Theodore and Elisabeth operate an Amway products
distributorship as an activity not engaged in for profit. They sold
$6,700 worth of Amway products at cost. Because they can
determine their gross income from the activity by subtracting the
cost of goods sold from their gross receipts, they report $0 on Line 21
of Form 1040.
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Reg. §1.183-1(b) gives ordering rules for the expenses:
Expenses that are otherwise deductible without regard to the
activity. Examples in this category include qualified mortgage
interest and property taxes.
Expenses incurred that would be deductible had the activity been
engaged in for profit but do not result in a basis adjustment. This
includes expenses other than depreciation or amortization, such as
contract labor, “business” meals and entertainment, advertising,
second phone line, utilities, “business” insurance, etc.
Expenses that are adjustments to basis are then allowed if there is
any income left to offset. That means depreciation or amortization.
Under the ordering rules, expenses that are normally deductible are
deducted on the return where they belong. For instance, qualified
mortgage interest is deducted on Line 10 and/or 11 of Schedule A and
real property taxes are deducted on Line 6 of Schedule A. Then, if the
preceding expenses do not exceed the amount of income earned from
the activity, the expenses from the second category are taken into
account as miscellaneous itemized deductions subject to the 2%
adjusted gross income (AGI) limitation on Schedule A. Finally, expenses
from the third category are allowed to the extent of the remaining
income, also a miscellaneous 2% item.
Reporting hobby related expenses on Schedule A, and limiting them to
the 2% AGI threshold may cause a taxpayer who actually breaks even
on the hobby activity to pay income taxes on the hobby. For example, if
hobby-related income and hobby-related expenses are each $5,000, the
expenses are included as miscellaneous itemized deductions, subject to
the 2% AGI limitation on Schedule A. After application of the 2% floor,
the expenses allowed are less than the $5,000 that was included in
The explanation of gross income and the ordering rules in
Reg. §1.183-1 given in the individual section are the same for the
partnership and partner. The partnership determines the amount of
gross income derived from the hobby activity and reports that income
to the partner on Line 11, with a code F (other income or loss). The
partner reports this income on Line 21 of Form 1040.
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The deductions for the hobby activity are reported to the partner on
Line 20 of the K-1, with the code X (other information). The partnership
should list the various expenses in each category listed under Reg.
§1.183-1(b) (i.e., otherwise deductible expenses, nonbasis adjustment
expenses, and basis adjustment expenses). The partnership determines
any limitation of deductions at its level (Rev. Rul. 77-320).
The partner reports these deductions the same as he or she would as
an individual (i.e., real property taxes on Line 6 of Schedule A, etc.).
S Corporation Reporting
The explanation of gross income and the ordering rules in
Reg. §1.183-1 given in the individual section are the same for the S
corporation and shareholder. The S corporation determines the amount
of gross income derived from the hobby activity and reports that
income to the shareholder on Line 10, with a code E (other income or
loss). The shareholder reports this income on Line 21 of Form 1040.
The deductions for the hobby activity are reported to the shareholder on
Line 12 of the K-1, with the code S (other deductions). The S
corporation should list the various expenses in each category listed
under Reg. §1.183-1(b) (i.e., otherwise deductible expenses, nonbasis
adjustment expenses, and basis adjustment expenses). The shareholder
reports these deductions the same as he or she would as an individual
(i.e., real property taxes on Line 6 of Schedule A, etc.).
Trust or Estate Reporting
The explanation of gross income and the ordering rules in Reg.
§1.183-1 given in the individual section are the same for the trust,
estate, and the beneficiary. Trusts or estates are slightly more
complicated in that they can be a pass-through entity or they can keep
the income and deductions for themselves or some combination thereof.
It is clear that if the trust or estate reports the income and deductions,
it has the same lines available as an individual. Other income is
reported on Line 8, taxes are reported on Line 11, and miscellaneous
itemized deductions subject to the 2% floor are reported on Line 15b.
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I've had four hobbies challenged in the last 15 years or so, and I've lost on three. Peterhawaii has laid out the technical requirements, but let me boil it down a little. The whole question boils down to three words. Is there a realistic profit motive? Do NOT ignore the word "realistic."
The first question is what has he been living on? If he makes a good living at an unrelated activity, the IRS is more likely believe there is no profit motive. Other red flags: an alternating pattern of large losses followed by years with small net income, lack of a systematic plan to achieve profitability, and if it's an activity in which it's inherently or historically difficult to make a profit (i.e., art, horse racing). They'll also be suspicious if there is too large an element of personal pleasure involved. I disagree with AM that you can make it work by showing a breakeven year two out of every five. IRS is onto that like white on rice.
By whatever means, you need to demonstrate a realistic profit motive. IRS is wise to almost every game taxpayers can play here.
By the way, the one I won was a cattle ranch that had lost money about 10 years in a row. No one would have worked like a dog the way my client did for fun, and the agent couldn't disagree. I've lost in situations where a shrink was raising hardwood lumber (near his weekend cabin), an machinist / artist (who sold about one painting a year), and a cardiologist with a quarterhorse ranch.
Thanks you all. The last 2 replies really helped. Because he has a full time job I am going to tell him he really needs to be aware of what he wants to do. And actually show him the replies.