IRS Hammered on Hobby Loss Case

The IRS has become real good at dumping on taxpayers whom they surmise may be engaged in a money-losing “hobby” operation.  Especially when the activity in question might carry with it an element of fun.

            But in a recent case, the Tax Court gives encouragement to folks whose money-losing efforts may very well qualify for subsidy by Uncle Sam.  It all comes down to just how serious the taxpayers are in their efforts.

            Seems Johnny L. Dennis and his wife were in the horse breeding business – in addition to a cosmetology business run by the Mrs.  The horses lost money, as is not uncommon.  Along come the Revenooers, who almost automatically declare anything to do with horses a “hobby,” thus disallowing the tax deductibility of the losses.

            “Not so fast,” said the Court.  In analyzing the facts and circumstances of the case, the Court concluded that the presumption of not engaging in the horse business with a profit motive was inappropriate.  And the Court’s reasons should give struggling business owners some encouragement.

  1. As to the manner in which the taxpayer carried on the activity, the Court found that a business plan was, indeed, in place, forecasting that a horse would become marketable after a 3 year period of nurture and training (despite the expectation of losses during some or all of those 3 years.)  Also the fact that the taxpayers maintained financial records and used accounting software strengthened their credibility.
  2. In analyzing the expertise of the taxpayers or their advisers with respect to the business, the Court found that Mr. Dennis sought advice from several individuals who were, in fact, familiar with how to make horse breeding profitable.
  3. Noting that the taxpayers spent vast amounts of time in their business, the Court was persuaded that the time and effort expended by them was strong evidence of their ultimate desire to make a profit.
  4. Mr. Dennis expected that the land used by his horse farm would eventually appreciate in value, and worked to this end by erecting barns, arenas, gates and fences.  This expectation that assets may appreciate in value can often indicate a profit motive to the extent that the ultimate gain on the sale of the assets just might offset the annual operating losses.
  5. Other substantial sources of income may sometimes indicate that a taxpayer does not engage in an activity for profit, particularly if personal or recreational features are associated with the activity – the problem which the typical “gentleman farmer” often faces in sustaining tax losses.  But in the Dennis’ case, their personal financial status was such that they really weren’t in a position to dabble in expensive “hobbies” of this magnitude – they were, in fact, struggling financially to sustain themselves.  Mrs. Dennis’ cosmetology business alone would not have been enough to support them if the horse losses continued interminably.

Bottom line – keep your nose to the grindstone in that business operation of yours – even

if it does carry along some elements of fun, and don’t immediately give up

if the Revenooers come calling, some day, with a “hobby loss” audit conclusion.

CONSULT YOUR TAX ADVISOR  – This article contains general information about various tax matters.  You should consult your CPA regarding the implications to your own particular situation.

            Jeff Quinn, the author of this article, is a shareholder in Ashley Quinn, CPAs and Consultants, Ltd., with offices in Incline Village and Reno.  He is also a contributor to the recently published 13th edition of Tax Savvy for Small Business, published by Nolo.  He can be reached at 831-7288, and welcomes comments below.

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