TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Sunday, September 16, 2007

TIGTA: Bright Line Rules Needed to Prevent Abuse of § 183 Hobby Loss Rules

The Treasury Inspector General for Tax Administration has released Significant Challenges Exist in Determining Whether Taxpayers With Schedule C Losses Are Engaged in Tax Abuse (2007-30-173):

About 1.5 million taxpayers, many with significant income from other sources, filed Form 1040 Schedules C showing no profits, only losses, over four consecutive Tax Years (2002 – 2005) .... By claiming these losses to reduce their taxable incomes, about 1.2 million of the 1.5 million taxpayers potentially avoided paying $2.8 billion in taxes in Tax Year 2005. Changes are needed to prevent taxpayers from continually deducting losses in potential not-for-profit activities to reduce their tax liabilities.

This audit was initiated because the IRS estimates incorrect deductions of hobby expenses account for a portion of the overstated adjustments, deductions, exemptions, and credits that result in about $30 billion per year in unpaid taxes. TIGTA conducted the audit to determine what actions the IRS is taking to address this potential noncompliance.

Section 183, also referred to as the “hobby loss” provision, and related Reg. § 1.183-1, do not establish specific criteria for the IRS to use to determine whether a Schedule C loss is a legitimate business expense without conducting a full examination of an individual’s books and records. The purpose of the hobby loss provision was to limit the ability of wealthy individuals with multiple sources of income to apply losses incurred in “side-line” diversions to reduce their overall tax liabilities. Our analysis showed 332,615 high-income taxpayers received the greatest benefit by potentially avoiding approximately $1.9 billion in taxes for Tax Year 2005.

The I.R.C. and Treasury Regulation do not require a taxpayer to have a reasonable expectation of profit; rather, the taxpayer needs just the “objective” of making a profit. Section 183 makes it difficult for the IRS to efficiently administer tax law that ensures taxpayers are not deducting not-for-profit losses to reduce their taxes on other incomes year after year.

TIGTA recommend[s] ... legislative changes to § 183. The proposal should include establishing a clearly defined standard or bright-line rule for determining whether an activity is a business or a not-for-profit activity.

https://taxprof.typepad.com/taxprof_blog/2007/09/tigta-bright-li.html

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