Expenses & Deductions
C corporations, S corporations, limited liability companies, limited partnerships, professional corporations, and nonprofit organizations all may be questioned by the IRS regarding profits, losses, and even whether the activity is a business or a hobby. For an activity to be considered a business, it must be engaged in for profit. If the activity is not engaged in for profit, it is subject to the hobby loss rules in Sec. 183. Whether an activity is a business or a hobby is important because under the hobby loss rules, the deductible expenses of a hobby are limited to the amount of income it generates and are further subject to a floor of 2% of adjusted gross income (AGI) as a miscellaneous itemized deduction.
Regs. Sec. 1.183-2(b) lists nine factors for determining whether a taxpayer engages in an activity for profit. However, these factors are not exhaustive, and each must be weighed in the context of the activity.
The first factor is how a taxpayer carries on the activity. A tax preparer would first want to look for how the taxpayer handles the entity, ensuring that he or she is conducting all activity in a businesslike manner. The taxpayer can establish this by maintaining separate personal and business bank accounts, keeping records and books, and acting like similar profitable, operational entities.
The second factor is the expertise of the taxpayer. A business operator should have extensive knowledge of his or her profession or activity, showing that he or she has studied accepted business methods and sought advice from experts.
The third factor is whether the taxpayer expends substantial time and effort in carrying out the activity.
Example: J manages a janitorial service, and his prime contract is with a fast-food chain. J also works three days a week teaching at a local university, and can clean the restaurants only late in the evening after closing or early in the morning before opening. This causes him to devote much of his personal time and effort to the cleaning.
Dedicating personal time to such an activity indicates that a taxpayer entered into the activity, or continued the activity, with the actual and honest objective of making a profit.
The fourth factor is an expectation that assets used in an activity, such as land, may appreciate in value. Regs. Sec. 1.183-2(b)(4) says such appreciation may be considered in lieu of current profits: “[E]ven if no profit from current operations is derived, an overall profit will result when appreciation in the value of land used in the activity is realized since income from the activity together with the appreciation of land will exceed expenses of operation.”
The fifth factor recognizes that even if the taxpayer’s activity is currently unprofitable, it may be for-profit if the taxpayer has been able to convert other activities from unprofitable to profitable in the past, especially ones similar to the current activity.
The sixth factor looks at the taxpayer’s history of income or losses from the activity. The economy plays a big role in how much business J, the hypothetical janitor, can generate and keep. Since J’s main contract is with a fast-food chain whose budget fluctuates with the economy, he sometimes incurs losses. Losses alone are not conclusive, because Sec. 162(a) allows “as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” However, a long series of losses warrants consideration, and sustained earnings indicate a for-profit activity.
The seventh factor examines the relative amount of the profits and losses. Regs. Sec. 1.183-2(b)(7) states, “The amount of profits in relation to the amount of losses incurred, and in relation to the amount of the taxpayer’s investment and the value of the assets used in the activity, may provide useful criteria in determining the taxpayer’s intent.” However, the presumption of profit motive in Sec. 183(d) says that if an activity has gross income for three or more of the last five years that exceeds the deductions attributable to the activity, the activity generally is presumed to be for-profit.
The eighth factor examines the taxpayer’s financial status, including whether he or she has other sources of income, although their presence does not preclude an activity from being considered for-profit. In the example, J also teaches three days per week at a local university during the academic year. He is not paid when school is not in session. Those months he relies solely on his janitorial business for income. J’s janitorial services can be considered a for-profit activity whether school is in session or not.
The ninth factor is whether the activity provides recreation or involves “personal motives” that may, with other factors, indicate lack of a profit motive. J’s janitorial service entails cleaning grills, mopping floors, and scrubbing public bathrooms. This activity lacks recreational appeal, helping J’s business to be seen as a for-profit activity rather than a hobby.
After reviewing the records and previous tax returns for an activity, a tax preparer can determine whether the activity is a hobby or a for-profit activity based on these nine factors. However, taxpayers must understand that there is no single, defining pattern or factor that is conclusive of whether an activity is for-profit or a hobby, and all the facts and circumstances must be considered. If an activity is deemed a hobby, its income is reported as other income on line 21 of Form 1040, U.S. Individual Income Tax Return, and the related expenses are reported as miscellaneous itemized deductions on Schedule A, Itemized Deductions, subject to the 2%-of-AGI floor.
Valrie Chambers is a professor of accounting at Texas A&M University–Corpus Christi in Corpus Christi, Texas. Robert Gard is a partner with Gard & Lefreniere LLC in Alpharetta, Ga. Prof. Chambers and Mr. Gard are members of the AICPA IRS Practice & Procedures Committee. For more information about this column, contact Prof. Chambers at valrie.chambers@ tamucc.edu.