- Horses, Hops, and the Hobby Loss Rules
- December 12, 2014 | Author: Timothy M. White
- Law Firm: Smith Haughey Rice & Roegge, P.C. - Traverse City Office
- If you take a drive through northern Michigan you are likely to come across at least a few horse farms. Increasingly, you may also spy large trellises draped with hops, and it seems as though anyone with more than an acre lot is planting a few grape vines these days. Sometimes, these horse and agricultural enthusiasts engage in their activities purely for personal enjoyment, never really seeking to derive much income (let alone a profit) from their passions. Others conduct their operations expertly and efficiently, consistently producing a healthy return on their investment. However, there are many who operate in the grey area, producing income but also incurring significant expenses, with only an occasional profit. These are the people who need to understand and account for the "hobby loss rule" of I.R.C. 183.
Most people understand that if they operate a business they get to deduct the expenses related to the operations for tax purposes. These expenses are deductible as a "trade or business expense" (i.e., generated from an activity which is engaged in for profit) under I.R.C. 162, or an expense incurred for the production of income under I.R.C. 212. People also understand that sometimes businesses lose money and losses from a trade or business are generally deductible, even against other sources of income. But what about activities which are not "engaged in for-profit" or "for the production of income?" Many people have hobbies that are able to produce some revenue, but for which they tend to have even higher expenses. These would include many involved with horses as well as some with small scale hobby farms. That is where I.R.C. 183, often referred to as the "hobby loss rule," comes into play.
Essentially, I.R.C. 183 limits a taxpayer’s ability to deduct the expenses of a hobby only to the extent of the income the hobby produces. It prevents a taxpayer from using a hobby to create a loss that could offset income from another source. This makes some sense because hobby expenses are more personal in nature and, in general, personal expenses are not deductible. If a taxpayer has losses disallowed because of I.R.C. 183, they can be liable to the IRS for additional taxes, penalties and interest.
In order to determine whether an activity is "engaged in for-profit," the taxpayer must show that there is a profit motive. This means that they have the "intent to generate receipts in excess of costs." Portland Golf Club v. Commissioner, 110 S. Ct. 2780, 2788 (1990). This is certainly a subjective analysis, but "the facts and circumstances must indicate that the taxpayer entered into the activity or continued the activity with the objective of making a profit. In determining whether such an objective exists, it may be sufficient that there is a small chance of making a large profit." Treas. Reg. §1.183-2(a). The regulations provide a list of nine factors that should be considered:
The extent to which the taxpayer carries on the activity in a businesslike manner
The taxpayer’s expertise or reliance on the advice of experts
The time and effort the taxpayer expends in carrying on the activity
The expectation that the assets used in the activity may appreciate in value
The taxpayer’s success in similar activities
The taxpayer’s history of income or loss from the activity
The amount of occasional profits, if any
The taxpayer’s financial status
The elements of personal pleasure or recreation
Treas. Regs. §1.183-2(b).
Of course, if the nine factor test stood alone, it would be difficult for taxpayers to determine with much confidence whether their activity qualified as a trade or business, or not engaged in for-profit and subject to the 183 limitation. To provide some clarity, the Code provides under certain conditions an activity will be presumed to be carried on for-profit. Generally, an activity which produces a profit in three of the last five years will be presumed to be carried on with a profit motive. In addition, I.R.C. 183(d) provides a special rule for activities related to horses, stating that such activities only require a profit in two of the last seven years.
However, taxpayers must be careful even where the presumption applies, as the IRS may be able to rebut the existence of a profit motive. Courts considering these issues have examined the reasons for losses and the taxpayer’s response to repeated losses. If losses could be explained by unexpected litigation, and without that unexpected expense there would have been a profit, then it suggests the taxpayer still had a profit motive. On the other hand, where a taxpayer faced with repeated losses did not change his practices to increase revenue or decrease expenses, it suggested the activity was not engaged in for-profit. In addition, where it appears a taxpayer may have manipulated the timing of income and expenses in order to trigger the presumption, the IRS may successfully rebut the presumption.
Understanding the hobby loss rule is important for those seeking to operate a horse-related business or a small scale farm. Due care needs to be exercised to demonstrate and document that the activity is indeed carried on with a profit motive. Failure to do so can put a taxpayer at risk of having losses associated with the activity disallowed, causing additional tax, penalties and interest to become due.