Is Your Business A Hobby in the Eyes of the IRS?
Investing in a “side business” when the main source of your net worth is derived from other businesses may result in a target on your back from the IRS. The Service continues to audit specific activities at a very high rate that have elements of pleasure, recreation or a hobby. Activities such as aviation, boat chartering, equine activities and vacation rentals are typically scrutinized under IRC Section 183, otherwise known as the hobby loss rules.
Typically, an activity will be reviewed over a period of years. In general, Section 183 of the Internal Revenue Code, enacted in 1969, provides that if a business engaged in by an individual, partnership or subchapter S corporation shows a profit in two years within a five year period (beginning with the first profit year), it will be presumed to be engaged in for profit, with a separate special election available for a new enterprise. If the activity is one engaged in for profit, then losses resulting from the business may be deducted from other income. Note that this period is extended to seven years in an agricultural business such as a farm or horse breeding operation.
Fortunately, we are not dealing in absolutes. Basically, without profits, the burden of proof shifts to the taxpayer in an audit situation to show that this is a business with a profit motive. The IRS regulations provide nine objective factors which have been used in the Courts to determine whether or not an activity is engaged in for profit.
1. THE MANNER IN WHICH THE TAXPAYER CARRIES ON THE ACTIVITY.
2. THE EXPERTISE OF THE TAXPAYER OR HIS ADVISORS.
3. THE TIME AND EFFORT EXPENDED BY THE TAXPAYER IN CARRYING ON THE ACTIVITY.
4. EXPECTATION THAT THE ASSETS USED IN ACTIVITY WILL INCREASE IN VALUE.
5. THE SUCCESS OF THE TAXPAYER IN OTHER ACTIVITIES.
6. THE TAXPAYER'S HISTORY OF INCOME OR LOSSES IN THIS ACTIVITY.
7. THE AMOUNT OF OCCASIONAL PROFITS, IF ANY, WHICH ARE EARNED.
8. THE FINANCIAL STATUS OF THE TAXPAYER.
9. ELEMENTS OF PERSONAL PLEASURE OR RECREATION.
The IRS does not add up positive and negative factors. Court cases have typically focused on the manner in which the taxpayer carries on the activity. Therefore, it is important to create a business plan, maintain accurate books and records, track time and effort, and make appropriate adjustments each year with a profit motive in mind. Devote considerable time to the business, even withdraw or reduce your time in other businesses, to demonstrate your commitment to the activity. If there is a legitimate reason for losses, document these reasons, such as accidents, economic downturns, and other setbacks.
It is important to note that experts, such as a Certified Public Accountant, should be engaged from the outset to establish a good defense should there be an audit. This is typically not a “do-it-yourself project.” Trusted advisors can assist with a business plan so that solid financial projections are developed, a marketing plan is established, accounting software is used, and a separation of business and personal income and expenses. An advisor can also assist with the timing of income and deductions to aid in developing profit years.
If you do receive the dreaded audit notice, all is not lost. At the agent/manager level, the process tends to be very robotic, a review of the factors above, a checklist of sorts. The Service has become very aggressive and economic substance is very real. For this reason, settlement at this level may not be recommended. To be successful, the accountant can perform an economic study for the industry and can minimize weaknesses in the specific situation. Engage experts who have expertise in the audit and appeals process. In a strong case, legal counsel can be retained specifically trained in the Tax Court arena.
In summary, establish your purpose for starting this business, form a business plan, and be flexible enough to adjust operations with a goal towards a profitable business.