The Sixth Circuit Court of Appeals recently confirmed that simply working hard for 15 to 20 hours each week does not turn a hobby into a for-profit business. The case of Zarins v. Commr, CA-6, June 17, 2002, shows that there is a difference between having a hobby (personal expenses) and having a business (for which tax deductions are available to the taxpayer).
The taxpayer started a tree farming activity on his land, devoting about 15 to 20 hours each week to the farm, mostly on irrigation and providing road access. He failed to sell many trees. Further, he did not keep records of the number of trees planted, and did not maintain a separate bank account for the farm. While he maintained records of expenses and income for tax purposes, he kept no other books and records for the farm. He did not have a budget, income or profit projections, and failed to get any expert advice on operating a tree farm for profit (he had no background in tree farming).
The taxpayer took deductions for expenses incurred for his tree farming activities, which the IRS denied on the grounds that the tree farm had not been operated for profit. The Tax Court and the Appellate Court agreed with the IRS.
Are You Running a Business For Profit?
If you do not carry on your business to make a profit, you can only take deductions to the extent of income—i.e., you cannot take a loss to offset other income.
An activity is presumed not to be a hobby if profits result in any three of five consecutive tax years. An activity involving the breeding, training, showing or racing of horses is presumed not to be a hobby if profits result in two of seven consecutive years. If your business has not met the above thresholds for attaining profit, the IRS will determine whether an activity is engaged for profit by referencing objective standards, taking into account all of the facts and circumstances of each case. This means if you have more loss years than indicated above, the losses can be deductible if it is determined that you are conducting an activity for profit, but just doing a bad job of it.
Facts and circumstances are of utmost importance. While no one factor alone is decisive, among the factors to consider are whether:
- You carry on the activity in a businesslike manner;
- The time and effort you put into the activity indicates you intend to make it profitable;
- You depend on income from the activity for your livelihood;
- Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business);
- You change your methods of operation in an attempt to improve profitability;
- You, or your advisers, have the knowledge needed to carry on the activity as a successful business;
- You were successful in making a profit in similar activities in the past;
- The activity makes a profit in some years, and if so, how much profit it makes, and/or
- You can expect to make a future profit from the appreciation of the assets used in the activity.
In Zarins v. Commr, the Sixth Circuit concluded that the Tax Court properly considered the nine factors to test whether the taxpayer operated his farm for profit. They concluded the following five factors were in support of the IRS’ determination (and that the other four factors were neutral):
Conducting the Activity: The taxpayer did not have a business plan or accurate production records.
Expertise: The taxpayer did not show he possessed expertise regarding the tree farming business, and failed to seek expert advice for operating the farm for a profit.
Time and Effort: The taxpayer was employed full time at another job. Though a pond and access road had been built, the taxpayer did not show to what extent these items had a direct connection to the farm.
Value Appreciation:Under Reg §1.183-2(b)(4), a taxpayer can intend to make an overall profit upon appreciation in value of assets used in the activity. An overall profit exists if net earnings and appreciation are enough for recouping losses sustained in previous years. The court found the taxpayer’s testimony unconvincing as to whether he expected the farm’s future appreciation to offset the cumulative losses.
Other Activities:Under Reg §1.183-2(b)(5), a taxpayer who has previously engaged in similar activities and made them profitable can show a profit objective more easily. The record failed to show how the taxpayer was previously involved in tree farming.
If your hobby is truly a hobby and not a business, then do not try and sell it to the IRS as a business.
If you are “putzing around at something that may turn into a profitable business,” you may want to elect to have the “presumption rules” apply after you have the five or seven years of experience allowed by the test. You can choose to do this by filing Form 5213, Election to Postpone Determination as to Whether the Presumption Applies that an Activity is Engaged for Profit. Filing this form postpones any determination that your activity is not carried on for profit until five or seven years have passed since you started the activity.
The benefit gained by making this choice is that the IRS will not immediately question whether your activity is engaged in for profit. Accordingly, it will not restrict your deductions. Rather, you will gain time to earn a profit in three or two of the first five or seven years you carry on the activity. If you show three or two years of profit at the end of this period, your deductions are not limited under these rules. If you do not have three or two years of profit, the limit can be applied retroactively to any year in the five-year (or seven-year) period with a loss. Filing Form 5213 automatically extends the period of limitations on any year in the five-year (or seven-year) period to two years after the due date of the return for the last year of the period. The period is extended only for deductions of the activity and any related deductions that might be affected.
In other words, if you do not take deductions greater than income, and then the activity becomes a profitable entity, you can amend the returns and take the deductions. Generally, you can only amend a return within three years of its filing due date. For more information regarding this topic, please contact Henssler Financial at 770-429-9166 or [email protected].