The IRC provides that an individual or S corporation cannot deduct expenses which are greater than the income from an activity if that activity is "not engaged in for profit." IRC Sec. 183 is often referred to as the "hobby loss" provision. Losses from a hobby are considered personal expenses and are not deductible, except to the extent that the losses consist of certain personal items which are specifically allowed as itemized deductions under the tax law--items such as taxes and interest.

Determining Profit Motive

According to the IRS, the determination whether an activity is a business depends on whether the facts and circumstances indicate that the taxpayer entered into or continued the activity with the objective making a profit. The IRS has listed nine factors which are normally taken into consideration in determining whether a profit objective exists |Reg Sec. 1.183-2(a).

It is important to note that objective factors are more important than the taxpayer's self-serving statements of intent to make a profit. The regulations state that no one of the nine factors is determinative, nor are the nine IRS factors the only factors to be considered. The regulations also state that the ultimate determination of whether a profit motive exists is not to be made by comparing the number of factors in favor of a profit motive with the number against a profit motive, or vice-versa. It is clear from reading the regulations that the "facts and circumstances" surrounding an activity are the most crucial criteria in determining whether the activity is a business or a hobby.

The IRC also provides that if an activity engaged in by an individual, estate or trust, or S corporation has profits for three years within a five consecutive year period (commencing with the first profit year), the activity will be presumed to be a business endeavor |IRC Sec. 183(d). Even if this presumption applies, the IRS can still take the position that the activity is a hobby, and not a business. However, once the taxpayer "satisfies" the "presumption," the burden of proof shifts to the IRS to show that the facts and circumstances still indicate there is no profit objective.

Factors to Consider

How Is It Being Done. The first factor is the manner in which the taxpayer carries on the activity. Most cases show that this factor must always be considered if the taxpayer's activity is going to be treated as a business, and not a hobby. The fact that the taxpayer carries on the activity in a businesslike manner, maintaining complete and accurate books and records, and carries on the activity in a manner similar to other profitable activities of the same nature are facts which may indicate a profit motive |Reg. Sec. 1.183-2(b)(1). In addition, changing operating methods, adopting new techniques, or abandoning unprofitable methods may also indicate a profit motive. For example, a taxpayer who obtains business licenses, cards, and stationery and prepares budgets and maintains separate bank accounts for his business, is well on his way to satisfying this factor. A taxpayer who is on the lookout for new techniques and methods that might improve the profitability of the activity may also be persuasive in evaluating this factor.

Expertise. The second factor is the expertise of the taxpayer or his advisers. Research and study into the economics of the activity and the use of this information in the conduct of the activity are indications of a profit motive. Conversely, if the taxpayer does not seek such information or obtains expert advice but does not follow it in the conduct of his activity, a lack of profit motive might be indicated. In trying to demonstrate to the IRS that the taxpayer is engaged in the activity for profit, it is beneficial if the taxpayer is knowledgeable about his business, attends seminars, and regularly reads books about the activity.

Time and Effort. The third factor is the time and effort expended by the taxpayer in carrying on the activity. By devoting a considerable amount of time to the activity, particularly if the activity does not have substantial personal or recreational aspects, a taxpayer can indicate his intent to make a profit. Partial or total withdrawal from another occupation to devote time to the activity may also be evidence that the taxpayer is engaged in it for profit. However, the fact that a person does not devote substantial time to the activity but rather employs competent and qualified persons to carry on the activity does not necessarily indicate a lack of profit motive.

Expectations of Appreciation. The fourth factor is the expectation that the assets used in the activity will appreciate in value. The IRS regulations specifically state that the term "profit" includes appreciation in the value of assets, including land, used in the activity. Thus, even if no profit is derived from the current operation, an overall profit may result if the appreciation in the value of the taxpayer's assets is taken into account along with the current income from the activity.

Prior Success. The fifth factor is the success of the taxpayer in other similar or dissimilar activities. The fact that the taxpayer engaged in similar activities in the past and converted them from unprofitable to profitable enterprises may indicate that the taxpayer is engaged in the present activity for profit even though the activity is presently unprofitable. This is true even if the taxpayer is involved in two different types of activities.

History of Income or Losses. The sixth factor is the taxpayer's history of income or losses with respect to the activity. A series of profit years is strong evidence that the activity is engaged for profit. A series of loss years during the initial period of operation or start-up stage of an activity is not unusual and may not necessarily be an indication that the operation is not engaged in for profit. However, losses that continue beyond the period normally required to make similar operations profitable can indicate that the activity is not engaged for profit, unless the continued losses can be justified as a result of unusual business risks. Losses sustained because of unforeseen or fortuitous circumstances beyond the control of the taxpayer, such as accident, disease, fire, theft, weather damages, other involuntary conversions, or depressed market conditions, would not be an indication that the activity was not engaged in for profit.

Amount of Occasional Profits. The seventh factor is the amount of occasional profits, if any, which are earned. The amount of profits in relation to the amount of losses incurred over the period of operation, and in relation to the amount of the taxpayer's investment and the value of the assets used in the activity, can provide useful criteria in determining the taxpayer's intent. For example, an occasional small profit from an activity which regularly generates large losses, or from an activity which the taxpayer has made a large investment would not generally be determinative that the activity is a business. On the other hand, a substantial profit, though only occasional, would generally indicate that an activity is engaged in for profit.

Financial Status. The eighth factor is the financial status of the taxpayer. If the taxpayer does not have substantial income or capital from sources other than the activity, the IRS will usually look upon this favorably. However, substantial income from other sources (particularly if the losses from the activity generate substantial tax benefits) may indicate that the activity is not engaged in for profit, especially if personal or recreational elements are involved.

Elements of Recreation. The final factor is whether the activity has elements of personal pleasure or recreation. Personal motives may indicate that the activity is not engaged in for profit. Conversely, the fact that the taxpayer does not derive any pleasure from the activity does not mean the activity is engaged in for profit. This "personal pleasure" factor probably is the factor which gives rise to the term "hobby" loss.

Alternative Presumption

Keep in mind that these nine factors are not all inclusive and that there are other ways to show an intent to be profitable (i.e., earning a profit).

In addition to the three profit years out of five (the "general" presumption), there is another type of presumption called the "alternative" presumption. The "alternative" presumption is similar to the "general" presumption in that the taxpayer must show profit in three out of five years. The distinction is that it covers the initial five years of operations and must be elected by the taxpayer within three years after the due date of the taxpayer's return for the taxable year in which the taxpayer first engages in the activity |Temp Reg. Sec. 12.9(c). The IRS is then precluded from making any hobby loss adjustments until the end of the five-year period, plus an additional two years |IRS Sec. 183(e)(4). The additional two years are intended to allow the IRS sufficient time to re-examine the activity for the entire five year period.

When the "general" presumption is used, the IRS has the authority to adjust the taxpayer's income/loss from the activity at any time. If the "alternative" presumption is available but not elected, the "general" presumption will still arise automatically if there are three profit years within a consecutive five-year period. An advantage of electing the "alternative" presumption is that it will apply to all years within the five-year period if there are three profit years in the period. The activity will have had a full five years to try to make three profit years. Under the "general" presumption, the taxpayer is "protected" in the third profit year and each year thereafter within the five-year period beginning with the first profit year (i.e., it is a prospective election). However, the "alternative" presumption applies to all loss years before the third profit year. The difference occurs when the profit years occur toward the end of the five-year period; the taxpayer is more "protected" with the "alternative" presumption.

However, few taxpayers have elected the "alternative" presumption, since the election alerts the IRS that the return includes possible hobby losses, as well as extends the statute of limitations. This normally will not outweigh the benefit of the election. Still, the taxpayer must use caution, as both the "general" as well as the "alternative" presumptions are only presumptions, not insurance policies.

Victory Without Presumption

A taxpayer can have an intent to show a profit even if he or she does not qualify for the presumption. For example, in Engdahl V. Commissioner, TC Memo NO. 56, the taxpayer incurred losses for the first twelve years of his operation but won the case. The Court felt that these losses occurred within the "start up years" of his operation, and losses in the earlier years of an activity are not unusual. Second, the losses could be explained by a series of unfortunate events beyond the taxpayer's control. Most importantly, the taxpayer operated in a businesslike manner: 1) books and records were prepared by his accountant, 2) the taxpayer advertised in numerous publications, and 3) the taxpayer employed a professional for advice. These facts persuaded the Court to decide for the taxpayer.

In 1984, Faulconer V. Commissioner, U.S. Ct. Appeals 4th Cir. No. 83- 2014, a case which Mr. Faulconer appealed by the taxpayer was able to show a net profit in only two of twenty-seven years and still won his case. The Court found that the taxpayer sought and followed advice from a hired expert and in the latter years of his activity had averaged annual gross receipts in excess of $83,000. The taxpayer also suffered several setbacks which led to losses in many of those twenty-seven years. This case illustrated that occasional profits are nonetheless important even though the profit years do not occur in a pattern which qualifies for the presumption.

Shifting the Burden of Proof

Normally the burden of proof falls on the taxpayer. Should the taxpayer be able to obtain a profit in three of the first five years, the presumption will be that the activity is a business, and the burden of proof will shift to the government.

The tendency of many who are beginning new businesses is to focus on cash flows in the early years. Part of that cash flow can stem from the tax deductions that start up losses can create. Little if any attention is given to the actual "profitability" of the business.

Wannabee entrepreneurs are well advised to budget and plan that start up operation to achieve profitability as soon as possible to minimize concerns about deductibility of losses in the early years.

It would be unfortunate if the IRS were to assess additional taxes and penalties because the aspiring Bill Gates failed to properly strategize the achievement of some level of profitability in the early years.