Taxpayers showing losses on Schedule C are in the spotlight
Impact on the Taxpayer
In general, if a taxpayer has hobby income and expenses, the expense deduction should be limited to the hobby income amount. About 1.5 million taxpayers, many with significant income from other sources, filed Form 1040 Schedules C showing no profits, only losses, over consecutive tax years 2002 - 2005 (4 years); 73 percent of these taxpayers were assisted by tax practitioners. By claiming these losses to reduce their taxable incomes, about 1.2 million of the 1.5 million taxpayers potentially avoided paying $2.8 billion in taxes in tax year 2005.
TIGTA has indicated to the IRS that changes are needed to prevent taxpayers from continually deducting losses in potentially not-for-profit activities to reduce their tax liabilities.
According to 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. The IRS faces considerable challenges in administrating the tax law for taxpayers who take Schedule C losses year after year for potentially not-for-profit activities.
Several recent efforts demonstrate these challenges. In an effort to change noncompliant taxpayer behavior, the IRS sent letters to taxpayers with potentially tax-abusive, home-based businesses as an alternate treatment to save audit resources. However, the taxpayer response rate was low, and IRS researchers concluded that the use of letters would not necessarily be productive as a tool to induce self-correction.
The IRS also conducted correspondence examinations. However, these examinations did not always deter taxpayers from continuing to claim hobby losses in succeeding tax years.
Internal Revenue Code (I.R.C.) Section 1834, Activities not engaged in for profit, also referred to as the "hobby loss" provision, and related Treasury Regulation 1.183-15 do not establish specific criteria for the IRS to use to determine whether a Schedule C loss is a legitimate business expense 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. According to the TIGTA analysis, 332,615 high-income taxpayers received the greatest benefit by potentially avoiding approximately $1.9 billion in taxes for tax year 2005.
The I.R.C. and Treasury Regulation do not require a taxpayer to have a reasonable expectation of profit; rather, the taxpayer needs just the "objective" of making a profit. I.R.C. 183 makes it difficult for the IRS to efficiently administer tax law that ensures taxpayers are not deducting not-for-profit losses to reduce their taxes on other incomes year after year.
TIGTA proposes legislative changes to I.R.C. 183, including establishing a clearly defined standard or bright-line rule for determining whether an activity is a business or a not-for-profit activity. In addition, due to the large number of tax returns with Schedule C losses being prepared by tax practitioners, TIGTA recommends that the IRS should continue to coordinate with practitioner organizations to encourage compliance with existing provisions.
You can read the complete TIGTA report  with the IRS response.