Many taxpayers have “side gigs” that can involve gains or losses that are significant enough to have important tax implications. For income tax purposes, there is an important distinction between hobbies and businesses, and losses for each type of activity have different tax treatments. This can be important in a down market.
1. Hobby Loss Rules
The “hobby loss” rule limits a taxpayer’s deductions if the Service determines that the taxpayer did not enter into the activity with a profit motive or that the taxpayer continued in a money-losing venture after the possibility of profit had lost its importance. Once it is determined that the activity was not profit-motivated, the amount by which deductions exceed income attributable to the activity (e.g., the amount of loss attributable to the activity) is not deductible. If an activity is not for profit, losses from that activity may not be used to offset other income. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.
2. Deductibility of Hobby Losses
The deductibility of hobby activity expenses may turn out to be limited in a particular case, however, because the deduction will be a miscellaneous itemized deduction. Miscellaneous itemized deductions are taken into account only to the extent that, in the aggregate, they exceed 2 percent of the taxpayer’s adjusted gross income. These deduction limitations apply to an activity continued without a profit motive from the time when the nature of the activity changed.
(More tax planning highlights: Tax Planning Countdown 2020)
3. Hobby or For-Profit Business?
Whether an activity is engaged in for profit is determined based upon all relevant facts and circumstances under IRC Section 183. Some factors that will be considered in determining whether or not the activity is profit-motivated include:
- whether the activity is conducted in a businesslike manner;
- the qualifications of the taxpayer or the taxpayer’s advisors;
- the amount of time and effort spent by the taxpayer or whether the taxpayer’s agents and employees are competent to carry on the activity (the taxpayer need not personally manage the operation);
- the potential for appreciation of the venture’s assets;
- the taxpayer’s history with similar or dissimilar programs;
- the taxpayer’s success or failure with the particular activity;
- the amount of occasional profits in relation to losses and to the amount of the taxpayer’s investment;
- the taxpayer’s financial status, whether he or she can benefit from losses, and whether the taxpayer’s main source of income is from some other activity; and
- elements of personal pleasure or recreation he or she derives from the activity.
4. Profit Expectations
A “reasonable” expectation of profit is not required, as when the probability of loss is much greater than the probability of gain. However, the taxpayer must engage in the activity with a genuine profit motive. All facts and circumstances are taken into consideration, but greater weight is given to objective facts than to the parties’ mere statements of their intent.
5. Sequence of Deductions
Deductions permitted by the hobby loss rule are determined and allowed according to the following sequence:
- amounts allowable under other IRC provisions without regard to whether the activity is profit-motivated;
- to the extent that the gross income attributable to the activity exceeds deductions allowable under (1) above, amounts that would be allowed if the activity were engaged in for profit and that do not result in basis adjustments;
- to the extent that the gross income attributable to the activity exceeds deductions allowable under (1) and (2) above, amounts that would be allowed if the activity were engaged in for profit and that result in basis adjustments, such as depreciation, partially worthless bad debts, and the disallowed portion of a casualty loss.
6. Application to Partnerships
Although IRC Section 183 addresses only the activities of individuals and S corporations, both the Service and Tax Court have taken the position that it also applies to partnerships. The rule is applied at the partnership level and is reflected in the partner’s distributive shares.
7. Successive Years of Profit
If the gross income from the activity (determined without regard to profit motive) exceeds deductions for three or more taxable years in a period of five consecutive taxable years, the activity is presumed to be conducted for profit. (The net operating loss deduction is not taken into account as a deduction for this purpose.) However, the Service is not prevented from attempting to rebut the presumption.
8. Postponing the Determination
The taxpayer may elect to postpone a determination of whether the presumption applies. The election postpones a profit determination until after the close of the fifth taxable year of the activity, so the Service will not try to limit deductions until the end of that year. Generally, the election must be made within three years after the due date (without regard to extensions) of the return for the first year of the activity. However, making the election extends the statutory period for assessment of deficiency until two years after the due date (without extensions) for filing the return for the fifth year.
9. What if the Taxpayer Dies?
If an electing taxpayer dies, the five year presumption period ends, even if profits are realized by the taxpayer’s estate in winding up the activity. As the estate is a separate entity from the taxpayer, the estate’s profits are not to be taken into consideration with regard to the for profit presumption in connection with the taxpayer’s activity in years prior to his or her death. The two year extension period for the statutory assessment of any deficiency begins to run from the time for filing a return for the year of death if death occurs during the five year period.