IRS Seeking To Tax Your Hobby
William P. Barrett 07/10/09 5:30 PM ET
At a time when the federal government is desperate for revenue, the Internal Revenue Service has issued a new manual to help its agents ferret out taxpayers improperly writing off the costs of hobbies.
The latest “audit technique guide” covers the application of what is known informally as the “hobby-loss rule.” This is the Internal Revenue Code provision–Section 183–that prohibits taxpayers from reducing their taxable income through losses generated from activities conducted primarily for personal pleasure, rather than as a profit-seeking business.
The effort to focus on hobby losses is the latest in a series of IRS initiatives scrutinizing taxpayers’ side ventures. The agency has solicited comments on how to implement a new law requiring payment card companies to report sales from taxpayers selling goods over eBay.
The new hobby loss manual, which can be viewed online here (www.irs.gov/businesses/small/article/0,,id=208400,00.html), contains a long list of hobbies that the IRS deems as red flags. It includes horse and dog breeding, yacht chartering, airplane leasing, gambling, photography, fishing, stamp collecting, bowling, writing and farming.
A 2007 report by the Treasury Inspector General for Tax Administration suggested that improper hobby loss claims cost the feds billions of dollars a year in tax revenues. But the manual itself acknowledged that historically, sorting out hobby losses “has been a difficult issue to pursue.”
While the manual is intended to help IRS agents detect wrongdoing, it also provides taxpayers with a wealth of information and tips on how to pursue a hobby with the best chance of getting Uncle Sam to pick up part of the tab.
The hobby-loss rule comes into play primarily when a taxpayer claims a loss on his tax return’s Schedule C (or, if for farming, on Schedule F) for a questionable activity and that loss is then used to offset other taxable income–like from a day job or investments. What can draw the most IRS scrutiny are claims of big losses for several years in a row.
Tax rules stipulate that there is a presumption the activity is legitimate if it shows a profit, no matter how small, in three of the past five years (two years out of seven for horse breeding). One strategy taxpayers might use to fulfill this requirement is to bunch expenses together to produce three years of small profits and two years of large losses.
Keeping good records and operating in a businesslike manner can go a long way toward convincing agents the pursuit is a vocation rather than an avocation. For instance, the IRS manual tells agents to ask during a face-to-face interview if there is an existing written business plan for the activity, suggesting taxpayers would be well advised to develop one at the outset. Agents also are instructed to ask if the activity has its own bank account–something taxpayers would do well to set up before the IRS begins asking for records.
The manual specifies questions that the IRS agent should ponder: “Are there activities with large expenses and little or no income? Are losses offsetting other income on the return? Does the activity result in a large tax benefit to the taxpayer? Does the history of the activity show that it is generating any profit in any years?”
IRS regulations list nine factors that agents are to weigh in evaluating a hobby-loss situation. Among them: the manner in which the activity is carried out, the expertise of the taxpayer, the time and effort involved and “elements of personal pleasure or recreation.” The manual provides plenty of guidance for taxpayers on how to address these issues.
Under the IRS’s interpretation of the hobby-loss rule, revenue and expenses from separate, unrelated activities cannot be combined unless the undertakings are “sufficiently interconnected.” Stated factors to be considered include the “degree of organizational and economic interrelationships of various undertakings.” The manual says a taxpayer’s characterization of what constitutes a single activity will be accepted unless it is “artificial and cannot be reasonably supported.” Translation: You’re probably not going to be too successful in convincing an IRS agent that a race horse owned Upstate is part of a New York City delivery business.
Besides consulting internal, super-secret IRS databases with cryptic names like IRDS, CFOL and YK-1, the manual counsels examiners to research taxpayers on the Internet using Google and Yahoo. Information found, the manual states, “should be compared with the taxpayer’s return.” So creation of a Web site touting the activity as a business and soliciting customers could work to the taxpayer’s advantage.
The IRS seems particularly obsessed with yacht chartering. One of the few case studies in the manual lists 25 documents that should be requested of taxpayers claiming related deductions, including copies of any promotional materials used to solicit charter business.
If admonitions in the manual are any indication, the IRS has had a problem with indignant agents. “An examiner should not tell a taxpayer that, because he is involved in a particular business activity, it is not possible to make a profit and his/her losses are thereby disallowed” the manual states. “Each taxpayer is entitled to be evaluated by a fair, impartial examiner.”
At one point the manual suggests that agents attempt an end-run around tax advisers that a taxpayer might bring to an audit interview. “Direct the questions to the taxpayer,” it states.
Bunch up expenses
IRS rules presume that a side activity is a legitimate business endeavor, rather than a hobby, if it shows a profit in three of the last five years. Try to incur expenses in a way that shows small profits in three years and large losses in the other two.
Write a business plan
The IRS manual says the existence of a reasonable “formal written business plan” drafted at the outset of an activity can be a favorable factor in regarding deductions as legitimate.
Operate like a business
Maintaining good records, getting a state sales tax identification number and opening a separate bank account can be evidence of intent to run a business and show a profit.
Display personal expertise
It will help your bid to deduct those Vegas gambling losses if you can document your long wagering experience and continuing efforts to improve your knowledge, such as buying books and taking courses on mathematics and risk.
Put in the hours
The more time and effort you devote to the activity, the greater your chance of convincing IRS agents you hope to make a buck from it. Keep a written log of your activities.
Make it one big ball of wax
IRS rules state that revenues and expenses from separate side activities–say bowling and dog breeding–cannot be combined unless they are “sufficiently interconnected.” The manual states that a taxpayer’s declaration should be given some weight, especially if supported with evidence of joint economic purpose or conduct. For instance, a taxpayer might be able cast himself as a lecturer on both topics.
Have an Internet presence
Since IRS agents are advised to research taxpayers on the Internet, creating a Web site promoting your activity as a business can work in your favor.
Let your tax adviser do the talking
The manual slyly suggests that during a face-to-face audit interview with a taxpayer and his tax adviser, IRS agents direct their questions to the taxpayer–who might not know the most tax-appropriate answer and whose answer might hurt the cause. Rather than playing along, politely refer queries to your hired help.
Act in good faith
If what you’re doing is truly just a hobby from which your sole return is personal pleasure, stop right there. It’s probably not worth the effort and potential risks to save what in many cases is pocket change.