Taxpayers showing losses on Schedule C are in the spotlight

The Treasury Inspector General for Tax Administration (TIGTA) has issued a report presenting the results of a review to determine what actions the Internal Revenue Service is taking to address noncompliant, high-income Small Business/Self-Employed (SB/SE) Division taxpayers who claim business losses using a U.S. Individual Income Tax Return (Form 1040) Profit or Loss From Business (Schedule C) for activities considered to be not-for-profit. This audit was part of the Treasury Inspector General for Tax Administration's Fiscal Year 2007 audit plan.

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.

Synopsis

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.

You may like these other stories...

As mentioned in today’s “Bramwell’s Lunch Beat” via an article from the USA Today, a new report from the Treasury Inspector General for Tax Administration (TIGTA) found that the IRS doled out $2.8...
London Stock Exchange switches auditing to EYThe London Stock Exchange will drop PwC as its auditor and replace it with EY after completion of the audit for the year ending March 2014, Harriet Agnew of the Financial Times...
With tax season in the past, it's time to think about the tax implications of decisions your clients may be making about their homes in 2014. The rules are complicated and because of the huge amounts involved, the...

Upcoming CPE Webinars

Apr 24
In this session Excel expert David Ringstrom, CPA introduces you to a powerful but underutilized macro feature in Excel.
Apr 25
This material focuses on the principles of accounting for non-profit organizations' revenues. It will include discussions of revenue recognition for cash and non-cash contributions as well as other revenues commonly received by non-profit organizations.
Apr 30
During the second session of a four-part series on Individual Leadership, the focus will be on time management- a critical success factor for effective leadership. Each person has 24 hours of time to spend each day; the key is making wise investments and knowing what investments yield the greatest return.
May 1
This material focuses on the principles of accounting for non-profit organizations’ expenses. It will include discussions of functional expense categories, accounting for functional expenses and allocations of joint costs.