The Hobby Loss Trap, Part 1
This article will discuss how an operation that is anticipating a few years of losses may prepare to defend against any assertions by the Internal Revenue Service (IRS) that their activity is a hobby. The current administration is looking for added revenue, especially from high-income earners. If the IRS is successful in a hobby loss assertion, expenses will simply be disallowed. The hobby loss rules prohibit taxpayers from deducting hobby expenses against hobby income, wages and other investment income. Therefore, it is important to be prepared to defend against any hobby loss assertions. The following is a brief review of the hobby loss rules and some tips on how to avoid being trapped by those rules.
Law History
Internal Revenue Code Section 183 “hobby loss provisions” was enacted as part of the 1969 Tax Reform Act in an effort to limit abuse of high-income earners who were receiving tax benefits by deducting personal expenses related to hobby-like activities. Treasury apparently considered it particularly applicable to gentleman farming. This assumption is derived from its placement in the Tax Reform Act under Subtitle B-Farm Losses,” however, these hobby loss provisions apply to any activity not engaged in for profit. In 2018 the Tax Cuts and Jobs Act (TCJA) provided for the suspension of miscellaneous itemized deductions in the years 2018 through 2025. This provision covers deductions related to a hobby which are now not allowed in those years. Prior to 2018, expenses from a hobby were allowed as a miscellaneous itemized deduction on Schedule A of a personal tax return. Currently, the inability of a rancher (“gentleman farmer”) to deduct even a portion of the hobby expenses while recognizing all the hobby income in adjusted gross income makes establishing a profit motive for a hobby activity even more imperative.
What are the Rules?
The determination of whether an activity is engaged in for profit is based on the facts and circumstances of each case and can be very subjective; however, a statutory safe harbor is provided that, if met, creates a presumption that the activity is a for-profit endeavor.
To meet the safe harbor presumption, an activity must generate a profit in at least three of five years (two of seven years for activities involving horse racing, breeding, or showing) ending with the tax year in question. If this safe harbor is met, the burden of proof for lack of profit motive is shifted to the IRS. The IRS can still rebut the profit motive presumption by proving that the activity is not engaged in for profit. The IRS may try to do that by showing that the profitable years generated immaterial profits while the unprofitable years generated large losses. However, in practice, if the safe harbor is met, the IRS will normally not attempt to rebut the presumption.
Applying the safe harbor presumption
Under the IRS regulations the safe harbor applies only for the third (or second) profitable year and all subsequent years within a five-year (or seven-year) safe-harbor period that begins with the first profitable year. That is as clear as mud.
Example - A rancher begins a new activity in year 1 and incurs losses from that activity in years 1, 3, and 6. The activity is profitable in years 2, 4, and 5. Assuming the five-year test applies to the activity, the five-year safe-harbor period begins with year 2 (because it is the first profitable year) and covers years 2-6. The safe harbor applies only for years 5 and 6 (because year 5 is the third profitable year after the start of the five-year period) but does not apply for years 1-4.
Thus, the IRS can assert that the losses incurred in years 1 and 3 must be reported under the hobby loss rules unless the rancher can prove otherwise under the subjective factors mentioned below.
Electing to postpone the safe-harbor presumption
A taxpayer may elect to delay a determination as to whether the safe harbor applies until the close of the fourth tax year (or sixth tax year, in the case of horse racing, breeding, or showing) after the tax year in which the taxpayer first engages in the activity. The advantage of this election over the general presumptive rule is that losses from the activity during the five-year period are tentatively allowed during that period (as opposed to being disallowed until the activity has been profitable for three years) and reported on Schedule F. If the election is made and the activity is profitable for three or more of the five years, the activity is presumed engaged in for profit throughout the entire five-year period. The election shifts the timing of the ability to use the safe harbor to an earlier period. However, if the election is made and the taxpayer fails the three-out-of-five-year test, the taxpayer may be faced with a substantial tax deficiency for all years involved.
To make a valid election, the taxpayer must file Form 5213, Election to Postpone Determination as to Whether the Presumption Applies That an Activity Is Engaged in for Profit, and execute a waiver of the statute of limitation. The election of Form 5213 is filed, separate from any other form or return, with the IRS Service Center where the taxpayer files his or her tax return. Filing Form 5213 automatically extends the statute of limitation for any deficiency attributable to the activity. The statute extension runs until two years after the due date (without extensions) of the return for the last tax year in the five-year (or seven-year) presumption period.
While filing Form 5213 allows a rancher additional time to establish the existence of a trade or business activity, it also alerts the IRS to a possible hobby loss issue. Thus, as a practical matter, Form 5213 should rarely be used until a rancher is notified by the IRS that it proposes to disallow hobby deductions.
The safe harbor rule is complicated and is not as protective as they seem. Your tax adviser should help answer your questions related to the safe harbor. Your adviser should also be of help in meeting the subjective factors in case the safe harbor is not established. Note the safe harbor provision introduces a new word “activity” which is narrower than the normal “Trade or business”. Be careful to develop documentation for each activity that occurs in your operation. Growing blueberries, hay, timber, and cattle breeding are just a few items that could be considered as separate activities.
The rancher that fails to meet the safe harbor criteria can still qualify his activity as a business, provided he can show that his activities were conducted with a profit-making motive or intent. There are nine relevant factors that the IRS will consider in determining the profitmaking intent which are as follows:
The manner in which the taxpayer carries on the activity. This is the most important factor according to the courts. It should cover separate accounting books and records used in each activity, a formal written business plan, detail methods of operation and show over time items to improve efficiency of operation
The expertise of the taxpayer or his or her advisors
The time and effort expended by the taxpayer in carrying on the activity
The expectations that the assets used in the activity may appreciate in value
The success of the taxpayer in carrying on other similar or dissimilar activities
The taxpayer’s history of income or losses with respect to the activity
The amount of occasional profits, if any, which are earned
The financial status of the taxpayer
The elements of personal pleasure or recreation
The meeting of five of the nine factors results in taxpayer wins at the audit level. Meeting those factors require good records and documentation which is the first factor. The Courts seem to believe that factor 1 is the most important. Historically, if you win it, you win in court.
There are court cases that show the importance of good documentation. An example of this was the case of Garbini v. Commissioner, T.C. Summary Opinion 2004-7. This involved the issue of whether the taxpayers were engaged in an activity for profit in connection with a cattle and horse breeding operation in Myrtle Creek, Oregon. Mr. Garbini, the taxpayer, did not maintain good books and records. He never prepared budgets or market forecast which supported strategies for a profitable business venture. He had no documentation that indicated what efforts he actually made to reduce expenses. Mr. Garbini worked on the ranch almost every day and employed one full-time ranch hand. He had no sales. Mr. Garbini testified, without any documentation, he bought the property for $566,000 in its undeveloped condition, and at the time of trial it was worth $15 million. The court ruled to disallow the deduction in the years in question since the taxpayer had minimal records to support his profit intent.
The IRS feels that factor 6, the base for safe harbor rule, is the most important factor for consideration. However, the Courts seem to believe that first factor is the most important. When a taxpayer operates his activities in a very business-like manner with well documented profit plans, accounting records, cost analysis and good communications showing reasonable efforts to achieve goals that will lead to a profit, the courts have ruled in the taxpayer’s favor even when there are years of losses. However, those that do not have those records, are likely to fall victim of the “Hobby loss disallowance provision”.
Summary
It is very important to maintain good accounting records which include a short-term and long-term business plan, budgets, cost control analysis and documented communication of decision to improve the potential profitability of each of your activities in your operations. Consideration should be given to the more burdensome accounting and recordkeeping that accompany the NOL requirements. The safe harbor rule is complicated and is not as protective as they seem. Try to meet it, if practical, but do not rely on it as your only defense against the hobby loss rule. If audited, consider the filing of Form 5213 if it would be helpful. Ranchers will need to spend more time before yearend to determine the appropriate amount of taxable income or in certain cases, net operating losses. It won’t be easy to get to the right number. Your financial advisor should be able to provide some guidance to help you lower your exposure to the hobby loss provisions.