Tax Court Corner: Untangling the Hobby Loss Rulesby
When you are in a business, the goal is to make a profit. However, there are some taxpayers who will have a side business and a regular full-time job.
The taxpayer will take losses on their Schedule C – S corporation or partnership – and these losses will flow to the taxpayer’s personal tax return, where the amount of their tax liability will be lowered because the business they are in will lose money.
Typically, when applying the hobby loss rule, the IRS will use the “three-out-of-five-year test.” If an activity shows a profit for any three or more years in a period of five consecutive tax years, it's presumed to be engaged in, for profit, unless the IRS establishes to the contrary. Code Section 183 is referred to as the “hobby loss rules” and stipulates whether a activity is a hobby or a business.
In the case of Kimbrough v. Commissioner, the Tax Court defined profit as “an economic profit, independent of tax savings.” In the case, Donald Kimbrough taught at Chicago Vocational High School and coached girls’ basketball and high school golf. Kimbrough began to seriously play golf in 1972 when he was in college.
In 1976, he began an unpaid apprenticeship program with the PGA. During the apprenticeship, he served as an assistant to the professionals at Pipe O’ Peace Golf Course. In 1985, Kimbrough satisfied the requirements and was elected a member of the PGA. He thought about leaving his position as a teacher to devote full time to golf, but he found teaching too rewarding.
Every day after fulfilling his obligations as teacher and coach, Kimbrough went to the Pipe O’ Peace Golf Course where he was able to practice golf. When there was inclement weather, he practiced indoors. Twice a month he went to Florida to play golf. In the summer months, he was able to devote 12 hours a day to golfing activities.
From 1978 to 1982, Kimbrough reported losses on his tax return for his golfing activities. All of his golfing expenses were substantiated to the IRS and to the court. The court found that Kimbrough’s golfing activities were engaged in for a profit.
In the opinion, the court stated: “The sole issue for our determination is whether petitioner’s golfing activity was an ‘activity not engaged in for profit’ within the meaning of Section 183. Section 183(a) provides, in general, that an individual will not be allowed any deduction attributable to an activity ‘if such activity is not engaged in for profit.’
Section 183(c)5 defines an activity ‘not engaged in for profit,’ as any activity that is neither a trade or business for purposes of Section 1626 nor for the production of income for purposes of Section 212(1) or (2). The threshold test for determining whether an activity constitutes a trade or business so as to allow a deduction for expenses under Section 162 is whether the primary purpose and intention of the taxpayer in engaging in the activity is to make a profit.”
Even though Kimbrough failed the three-out-of-five-year test, the court still determined that the activity had a profit motive.
On the contrary, in the case of Gabriel J. Loup v. Commissioner, TC Memo 2009-23, the court found the opposite was true. Loup was a nurse who was an aspiring actor/comedian.
In this case, the petitioner was audited by the IRS because he incurred expenses in connection with his acting/comedy activities. The IRS disallowed the expenses, stating that the expenses were in connection with a hobby. The petitioner lost on appeal and took the case to the Tax Court.
In the Tax Court memo, the court stated the facts of the case. In October 2002, the petitioner signed a one-year contract with a talent agent. The petitioner worked as a pharmaceutical company representative and a licensed intensive care nurse.
The petitioner claimed that in 2002 or earlier, he became a member of the sketch comedy group 9 Layer Dipz. The members of this group wrote, produced, and directed their own comedy show.
On his timely filed 2003 Form 1040, the petitioner claimed $12,811 worth of expenses that were for his pursuits in this comedy group. The only proof of expenses the petitioner had was a log that the court contended were personal expenses. The court also contended that the activity was not a going concern and ruled in favor of the IRS.
Even famous attorney F. Lee Bailey has been to Tax Court over hobby loss rules. In F. Lee Bailey, et al. v. Commissioner, the petitioner was an attorney/author who claimed expenses for a yacht rental and refurbishing company, and airplane-remanufacturing expenses were denied for both estoppel and hobby loss rules.
Estoppel is the principle that precludes a person from asserting something contrary to what is implied by a previous action or statement of that person or by a previous pertinent judicial determination.
The court doesn’t always side with the Commissioner on what the IRS defines as hobby loss rules. Over and over again, the court will side with a petitioner, even if the three-out-of-five-year test isn’t met, provided there is an aggressive pursuit of income.
We hope these Tax Court columns are useful or informative to you and we welcome your feedback.
Craig W. Smalley, EA is the CEO and Founder of CWSEAPA®, PLLC, located in Orlando, Florida, with clients all over the country in every industry. He has been admitted to practice before the IRS as an Enrolled Agent, and has a Master's Certificate in Taxation from UCLA. He has been in practice since 1994, specializing in individual, partnership...