by Tiffany Michelle Hunt, J.D., LL.M.
Introduction
The purpose of this article is to guide the reader on how to prove and what to do to have the IRS recognize your hobby as a profit-making venture (i.e., tax-recognized business) for which you can use expenses to create deductible losses. Coupled with our firm's position on Section 119, this could save you thousands in taxes. We commend you for being diligent and proactive in researching the law, but we implore you to contact us to schedule a free consultation. Even if you don't engage our firm, you would seriously benefit from a free no-cost consultation with one of our tax attorneys.
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Background
Under Section 162, a taxpayer can deduct all ordinary and necessary expenses related to a trade or business.[1] For the expense to be deductible, it needs to be paid or incurred during the taxable year.[2] The expense must be “ordinary and necessary.”[3] An expense is “necessary” if it is appropriate and helpful in advancing the taxpayer’s business.[4] Within the meaning of Section 162, the term “ordinary” helps with determining whether the expense is one that a person can deduct in-full or whether the expense should be depreciated or amortized over the asset’s useful life.[5]
Both Ordinary and Necessary
In Welch v. Commissioner, the U.S. Supreme Court held that a former officer paying a corporation’s discharged debt was a “necessary” but not an “ordinary” expense. In that case, the officer had no legal obligations to pay such debt. Nevertheless, the expenditures were necessary for enhancing the company’s reputation.[6] However, the Court sided with the Internal Revenue Service in characterizing the expenses as capital expenditures, and, therefore, not ordinary expenses. The Court stated that “the Commissioner of Internal Revenue resorted to that standard in assessing the petitioner's income, and found that the payments in controversy came closer to capital outlays than to ordinary and necessary expenses in the operation of a business.”[7] Capital expenses cannot be deducted all at once in a tax year, but a taxpayer can recover the cost over time through depreciation or amortization. A taxpayer can deduct a portion of the expenses each year.[8] For that reason, the taxpayer in Welch was not able to take a current expense deduction for his full debt payments.[9]
Activity with Intent to Profit
Additionally, a taxpayer must incur the expense in a “trade or business,” which the Code does not define. The Code only describes what does not constitute as a trade or business, such as performing services as an employee in the limited context of the deductibility of business interest.[10] Furthermore, hobbies or sporadic activities do not constitute a trade or business.[11] The entire historical jurisprudence interpreting the phrase “trade or business” can be summarized into three classifications: An activity to generate a livelihood or profit,[12] a pursuit of economic activity with a present intent to create a profit,[13] or an enterprise that involves regular activities and transaction to generate an income.[14] The taxpayer at issue must have a good-faith intent to realize an economic profit. Attempting solely to achieve tax savings is not considered an economic profit.[15]
While the taxpayer has to prove a good faith intent to earn a profit, the taxpayer does not have the burden to prove the reasonableness of such intent.[16] In Doggett v. Burnet, the petitioner became a follower of the late English Bishop, Joanna Southcott. The bishop’s followers believed that the British government sealed some of the bishop’s writing in an arc and will release those in 1914. In 1917, the petitioner returned to the U.S. to engage in the business of publishing, marketing, and selling the works of Joanna Southcott.[17] She believed that she could earn a small profit before the arc was opened and realize a huge profit after the opening. The arc was never opened.[18] Despite, the lack of profit or any indication of future profits, the appellate court reversed the tax court’s decision and found that the petitioner had good-faith intent.[19] The appellate court stated that reasonableness is not the proper test but rather whether the taxpayer entered the trade or business with the actual subjective intent of earning a profit.[20]
One can easily see that the primary focus here is on intent. If the trade or business realized profits in three of the past five years, then there is an assumption that the business was entered into with the intent to make a profit.[21] This presumption applies at the end of the third year.[22] It is important to note that passive income from passive investments do not qualify as business profits.[23] If a taxpayer is engaged in an activity without an intent to earn an active business profit, then the taxpayer can only deduct amounts allowable to the extent of realized gross profits under Section 183(a).[24]
A taxpayer has the burden to prove that there was a bona fide intent to realize a profit based on the totality of the circumstances.[25] In Laramont v. Commissioner, the taxpayer failed to prove such an intent. He was a lecturer who also published books.[26] He only had two profitable years in a twelve-year period.[27] Even though he conducted himself in a business-like manner over the last thirty years, the court ruled that he did not have a bona fide intent to make a profit. [28] The taxpayer was a wealthy man whose financial status was unaffected by the lack of income each year. The court found that the taxpayer’s financial status, activities, and personal background indicates a lack of intent to earn a profit.[29]
Section 183 | The Nine Factors
But what if there is no intent to realize an immediate profit? Every reasonable business person knows that profits are not instantaneous and one has to lay the groundwork to harvest a benefit. If the taxpayer does not realize an immediate profit, the nine factors under the Treasury Regulation Section 1.183-2(b) serve as a guideline to determine whether there is an intent for profit. Each case is resolved on its facts, and meeting one or even several factors does not offer a safe harbor.[30]
First: The first factor looks at the manner in which the taxpayer carries on the activity. The taxpayer can meet the first factor by showing that accurate books and records were kept, or by showing that the business changed its operation methods and adopted new technology to assure profitability.[31]
Second: Second, the expertise of the taxpayer or his advisors can show a profit motive.[32] In Nickerson v. Commissioner, the petitioner and his family purchased a farm approximately five hours away from their hometown.[33] The family’s goal was to cultivate the land over time and turn the farm into a profitable business venture.[34] Since the farm and its surrounding area was hugely neglected, the petitioner intended to live off the profit from the farm when he reached the age of retirement.[35] The tax court incorrectly ruled that the petitioner’s lack of expertise indicated that he did not have an intent to realize profits since his only farming knowledge stemmed from his childhood. However, the appellate court overturned the decision and ruled that not only current expertise are essential but also the efforts to gain experience and the willingness to follow the expert’s advice.[36]
Third: The third factor looks at the time and effort spent in carrying on the activity. Here, the courts look at whether a taxpayer devotes personal time to the business, or even withdrew from a different occupation to spend more time on the trade or business. However, the lack of devotion does not indicate a lack of intent if competent and qualified personnel was hired.[37] In Nickerson, the appellate court held that the petitioner, who engaged in farming business for future profit, devoted enough time at the farm. The petitioner met the factor even though he only visited the farm regularly during the growing season.[38] Here, his lack of devotion to spending time at the farm was not inconsistent with his intent to earn a profit because he leased the land to a tenant-farmer for cultivation.[39]
Fourth: The next factor focuses on the taxpayer's expectation that assets used in the activity may appreciate in value. Since profit includes appreciation in value, a taxpayer can have the intent to achieve a profit through the land’s appreciation in value. A profit in such scenario is realized if the income from the activity plus the appreciation in the value of land exceeds operational costs.[40]
Fifth: The taxpayer’s success in carrying on a similar or dissimilar business is another factor. The taxpayer must show that he was able to convert a previous unsuccessful business into a profitable one.[41]
Sixth: The sixth factor looks at the taxpayer’s history of income or losses in regards to the activity. Losses at the beginning of a business do not show a lack of profit motive. However, if the taxpayer prolongs the losses beyond a reasonable time, it could indicate a lack of intent to realize a profit.[42]
Seventh: Another factor examines the occasional profits if there are any. If the occasional profits are large and the losses are comparatively small, then there is a strong indication that there is an intent for profit. On the other hand, small, occasional profits combined with substantial losses do not automatically determine a lack of profit intent.[43]
Eighth: The eighth factor considers the financial status of the taxpayer.[44] In Nickerson, the appellate court pointed out that if the petitioner were wealthy, then the court would be hesitant in reversing the tax court’s decision. However, in that case, the petitioner was of modest means with the intent to create a financially stable future for his family. His overall financial status indicated that the farming activity was for profit.[45]
Ninth: The last factor focuses on any possible element of personal pleasure or recreation. The lack of any personal motive except earning a profit is a strong indication of such intent; although, the activity does not have to be completely void of a recreational or personal aspect. It will not be characterized as a not for profit just because the taxpayer receives personal satisfaction from the activity. However, the taxpayer must enter the trade or business with the primary intent to earn a profit.[46]
The Nickerson case discussed above is a clear indication of how erroneously the Internal Revenue Services and the tax court applied some of the factors under Treasury Regulation Section 1.183-2(b). The taxpayer was denied the deduction because the tax court doubted that it is reasonable that the petitioner can earn a profit with his current level of activity. Additionally, the tax court (and the Internal Revenue Services) did not believe that there was a bona fide intent to earn a profit because the taxpayer spread out the start-up losses over an extended period before engaging in the farming operation full-time.[47] The appellate court, however, stated that their disagreement with the tax court stem from the improper evaluation of the taxpayer’s situation. The taxpayer did not have to prove that a current profit is obtainable, but only that there was a sincere belief that their current action was motivated with a bona fide intent to make a profit in the future.[48] In regards to spreading out losses, the appellate court stated that there is no difference in observing a substantial loss over a short period to start operation sooner, or in spreading out the losses in smaller amounts over several years and, consequently, beginning the operations later.[49]
Each case and each taxpayer’s situation is unique. The issue whether there was an intent to earn a profit is fact-specific. It does not only depend on the activity itself but also on each taxpayer’s situation. You can read the IRS's Audio Technique Guide to see how they approach inquiries.
Conclusion
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Footnotes of Legal Authorities
[1] See IRC §162(a) Trade or Business Expense: (a)In general There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including(1) a reasonable allowance for salaries or other compensation for personal services actually rendered(2) traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business; and(3) rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.
For purposes of the preceding sentence, the place of residence of a Member of Congress (including any Delegate and Resident Commissioner) within the State, congressional district, or possession which he represents in Congress shall be considered his home, but amounts expended by such Members within each taxable year for living expenses shall not be deductible for income tax purposes. For purposes of paragraph (2), the taxpayer shall not be treated as being temporarily away from home during any period of employment if such period exceeds 1 year. The preceding sentence shall not apply to any Federal employee during any period for which such employee is certified by the Attorney General (or the designee thereof) as traveling on behalf of the United States in temporary duty status to investigate or prosecute, or provide support services for the investigation or prosecution of, a Federal crime
[2] C.I.R. v. Lincoln Sav. & Loan Ass’n, 403 U.S. 345, 353 (1971).
[3] Welch v. Helvering, 290 U.S. 111, 115 (1933).
[4] C.I.R. v. Tellier, 383 U.S. 687, 689 (2010).
[5] Id. at 690.
[6] Welch, 290 U.S. at 113.
[7] Welch, at 290 U.S. at 114.
[8] Business Expenses, I.R.S Pub. No. 535, Cat. No. 15065Z (March 16, 2018), https://www.irs.gov/publications/p535 # en_US_2017_publink1000208610
[9] Welch, 290 U.S. at 115.
[10] IRC §163(j)(7)(A)(i).
[11] C.I.R. v. Groetzinger, 480 U.S. 23, 35 (1987).
[12] Snyder v. C.I.R., 295 U.S. 134, 140 (1935).
[14] C.I.R. v. Groetzinger, 480 U.S. at 35.
[15] Campbell v. Commissioner, 868 F.2d 833, 836 (6th Cir.1989); Hayden v. C.I.R., 889 F.2d 1548, 1552 (6th Cir. 1989).
[16] Doggett v. Burnet, 65 F.2d 191, 194 (D.C. 1933).
[17] Id. at 192.
[18] Id.
[19] Id. at 193.
[20] Id. at 194.
[21] IRC §183(d)
[22] Mitchell v. C.I.R., T.C, Memo 2005-145, T.C.M. (RIA) 2006-145, 92 T.C.M. (CCH) 17 (2006).
[23] Higgins v. C.I.R., 312 U.S. 212, 218 (1941).
[24] Golanty v. C.I.R., 72 T.C. 411 (1979), aff'd mem., 647 F.2d 170 (9th Cir. 1981).
[25] Tres. Reg. §1.183-2(a)
[26] Laramont v. C.I.R., 339 F.2d 377, 379 (2nd Cir. 1964).
[27] Id.
[28] Id.at 379-80.
[29] Id. at 380.
[30] Treas. Reg. §1.183-2(b)
[31] Treas. Reg. §1.183-2(b)(1).
[32] Treas. Reg. §1.183-2(b)(2).
[33] Nickerson v. C.I.R., 700 F.2d 402, 403 (7th Cir.1983).
[34] Id.
[35] Id.
[36] Id. at 407.
[37] Treas. Reg. Treas. Reg §1.183-2(b)(3).
[38] Id at 404.
[39] Nickerson, 700 F.2d at 403.
[40] Treas. Reg. 1.183-2(b)(4).
[41] Treas. Reg. §1.183-2(b)(5).
[42] Treas. Reg. §1.183-2(b)(6).
[43] Treas. Reg. §1.183-2(b)(7).
[44] Treas. Reg. §1.183-2(b)(8).
[45] Nickerson, 700 F.2d at 407.
[46]Treas. Reg. §1.183-2(b)(9).
[47] Nickerson, 700 F.2d at 406.
[48] Id.
[49] Id. at 404.