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Taxpayers are generally allowed a deduction from income for ordinary and necessary expenses paid or incurred in carrying on a “trade or business” under Section 162(a) of the Internal Revenue Code. A wrinkle arises when a taxpayer attempts to use deductions from one venture to offset income from a separate venture.

This is entirely proper under Section 183 of the Internal Revenue Code (the Hobby Loss Rule), and the business expense thus potentially deductible across venture lines, so long as the venture creating the loss is undertaken in good faith for the purpose of making a profit. And therein lays the question frequently litigated against the Internal Revenue Service (IRS).

Many years ago, some wealthy businesspersons and their professional advisors developed a plan to treat recreational pursuits as business ventures in order to use their inevitable losses (generated by their expenses) to offset other income.

The stereotypical situation involved a taxpayer with means and a full-time job who also owned a “gentleman’s farm” as a weekend retreat. For example, the taxpayer kept horses to entertain himself, his family, and friends. He dabbled in breeding horses with no expectation of ever making a profit.

But, he then deducted the expenses of his horses from his other income. As the United States Tax Court commented in a recent decision, “Uncle Sam subsidize[d] the weekend farm.” Imagine the weekend duffer deducting greens fees and golf equipment purchases from his regular income under the business plan of training to become a professional golfer?

Whether a taxpayer is carrying on a business for the purpose of realizing a profit, or is merely attempting to create and utilize losses to offset other income, is a question answered by considering all facts and circumstances with respect to the activity.

Section 183 was enacted to develop an objective standard to help with that examination to determine the taxpayers’ intent. An activity constitutes a “trade or business” within the meaning of Section 162, and it escapes the limitation of Section 183, if the taxpayer’s actual and honest objective is to realize a profit – even if the expectation of profit is not reasonable.

The mere fact that the business does not generate a profit in and of itself is not determinative. It is possible that sustained losses by a taxpayer can be explained. For example, such consistent losses may be countered by the reasonable expectation that the business assets would increase in value. However, there is a presumption that a venture is not an activity engaged in for profit if it does not show a profit during three of the past five years.

Treasury Regulation 1.183-2 sets forth nine factors to consider. It is not an exclusive list and no one factor is determinative. Rather, Regulation 1.183-2 supports a wide-ranging qualitative analysis.

The factors are:

(1)       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 assets used in activity may appreciate in value . . . .

(5)       The success of the taxpayer in carrying on other similar or dissimilar activities . . . .

(6)       The taxpayer’s history of income or losses with respect to the 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 . . . .

Included in several of these factors is a consideration of how the taxpayer operates and conducts the activity. Notably, is it treated like a separate, viable, stand alone business?

As examples, (i) has the taxpayer established a registered business entity for the activity, such as a corporation or limited liability company; (ii) does the taxpayer keep proper business and accounting records; and (iii) are the activity’s funds commingled with the taxpayer’s personal funds, or with another business or activity?

To borrow a colleague’s view, an audit and/or judicial review will look at the taxpayer’s conduct, or more importantly the lack thereof, in reaching a conclusion. As previously mentioned, none of these factors is controlling in and of itself, and a decision as to a taxpayer’s intent is not governed by a preponderance of the factors.  All facts existing during the time periods at issue are relevant and should be considered.

It is likely that an audit will expressly investigate and comment on the above factors, the business’ profit history, and anything else that will question the taxpayer’s motives (auditors can be creative). Such investigations tend to be of the “everything and the kitchen sink” variety.

As a result, any audit defense and potential appeal down the road will need to address these factors in a favorable light with legitimate and tangible evidence. As you might imagine, claiming “But, I intended to engage in the business for profit!” does not, in and of itself, carry much weight.

The Tax Code and Regulations permit taxpayers the ability to deduct ordinary and necessary business expenses from income. However, taxpayers should be mindful and careful of extending those deductions across venture lines.

The Section 183 analysis is intended to be an objective and comprehensive review of all relevant facts to determine whether a taxpayer’s intent as to a particular venture is honestly one to generate a profit. However, because of the resulting and substantial gray area between deductibility and a Hobby Loss (there is no bright-line rule), taxpayers run a very real risk of claimed deductions later being disallowed, and then promulgating penalties and interest – the painful salt in a fresh wound.