Caught Twixt a Rock and a Hard Place: The IRS and Hobby Losses

I’ve blogged about hobby losses a few times. Section 183 of the Internal Revenue Code generally disallows business tax deductions for activities “not engaged in for profit” – hobbies. The regulations under Section 183 provide a nonexclusive list of nine factors used to analyze a taxpayer’s profit objective with respect to an activity. In the last month or so, two authorities have weighed in on the IRS’ and, in one case, the Tax Court’s handling of hobby losses.

The Treasury Inspector General for Tax Administration (“TIGTA”) is, in substance, the Treasury’s internal auditor of the IRS. TIGTA issued a report on April 12, 2016, that criticized the IRS for not using its supposedly vast (if somewhat defective) “big data” skills to identify high-income individual returns (defined as reporting wages of at least $100,000) that had multiple years’ of losses reported on Schedule C, Profit or Loss From Business. Basically, TIGTA urged the IRS to go after taxpayers who must, in its opinion, be hobbyists, citing the 687,382 taxpayers who in tax year 2013 reported over $7.1 billion in losses from Schedule C businesses that also reported losses in the previous three tax years. I paraphrase the IRS’ response: “We’ll jump right on it.”

Within a month of the IRS receiving this guidance, the Seventh Circuit Court of Appeals applied some good ol’ Midwestern logic in issuing a blistering rebuke of the Tax Court’s and the IRS’ treatment of the losses from a horse breeding operation as hobby losses in Roberts v. Commissioner.

In 1999 Mr. Roberts bought two horses, for $1,000 each, and netted that year $18,000 of profit. He was hooked and, the best I can tell, never made a profit again. The Tax Court considered 2004 and 2005 losses and ruled them to be nondeductible. The IRS said that in 2006 through 2008 (the last year in the record of this case), Mr. Roberts had a horse breeding business that produced business losses and was not a hobby. Thus, the Tax Court did not rule on those years.

To say that the Seventh Circuit was critical of the Tax Court’s decision is an overwhelming understatement. I excerpt just a few of its observations:

“The Tax Court’s finding that his purchase and improvements were irrelevant to the issue of profit motive until he began using the new facilities is unsupported and an offense to common sense.”

“We mustn’t be too hard on the Tax Court. It felt itself imprisoned by a goofy regulation.”

“The court careens from profit motive to pleasure motive and back. All that emerges from the opinion and the record . . . is that Roberts enjoys his new career [in horse racing].”

“It may have been a fun business, but fun doesn’t convert a business to a hobby. If it did, Facebook would be a hobby, Microsoft and Apple would be hobbies, Amazon would be a hobby, etc., ad infinitum.”

So, what are my takeaways?

-The IRS will probably be more aggressive of its auditing returns with Schedule C losses.
-Don’t report a business you enjoy on Schedule C, particularly if it has losses.
-Relocate to Illinois, Indiana, or Wisconsin if your Schedule C has losses.

VKM