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Making Judgments in Applying Hobby Loss Rules

Mar 26th 2018
hobby loss rules

This is how much blanket advice can harm you and your client. The general rule of Hobby Loss Rules is that you can only take losses for three years. We have all heard that and have even given that advice. Where that advice is true is when a client has zero income and a bunch of expenses on a Schedule C for over three years. However, there is one situation that you may not be taking into account.

The Hobby Loss Rule has an exception: What if the client is “aggressively pursuing” income. What is meant by aggressively pursuing income? They have gross income and are just, through the normal course of business, losing money. What can the IRS say about that?

I had an audit in which a client had losses for five years. The agent tried to employ the Hobby Loss Rules and disallow the losses that the client incurred. From the returns you could see that the client was not only aggressively pursuing income, their loss was due to the depreciation laws.

This is where you need to make a judgment call. If a client has had no income and a lot of expenses for over three years, then they are not aggressively pursuing income. A few years ago, there was an IRS warning about tax preparers fraudulently stating that their clients had at-home businesses. The problem was that their clients never earned any income and just had expenses. This lowered their taxable income, inflating refunds.

I was doing a tax return for a client this year. I received tax returns from 2014 to 2016, all of which showed no income on a Schedule C but included a bunch of expenses. He gave me a W-2 and a spreadsheet listing home-office deductions. Forget the fact that he had no income but had a home office, where he was supposed to produce income. I emailed him and stated that I couldn’t take the deduction for the home office. I told him that taking the home office deduction, along with no income, was odd. However, the clincher was I told him this was his fourth year of taking expenses, with no income, and that would set him up for an audit. He seemed to understand that.

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