Paul L. Caron

Sunday, May 8, 2016

TIGTA:  IRS Mischaracterizes 88% Of Hobbies As For-Profit Businesses, Allowing Billions In Improper Loss Deductions

TIGTAThe Treasury Inspector General for Tax Administration has released Opportunities Exist to Identify and Examine Individual Taxpayers Who Deduct Potential Hobby Losses to Offset Other Income (2016-30-031):

The Treasury Inspector General for Tax Administration (TIGTA) today publicly released its audit report of the Internal Revenue Service’s (IRS) methods of addressing taxpayers who take business tax deductions for activities not engaged in for profit. TIGTA found that the IRS can improve its methods for identifying high-income taxpayers who may be offsetting their income with “hobby losses” from unprofitable business activity.

The tax code allows taxpayers to deduct all ordinary and necessary expenses paid or incurred in carrying on a trade or business. However, in the “hobby loss” provision in the tax code, the IRS generally disallows business tax deductions for activities not engaged in for profit.

A September 2007 TIGTA report found that approximately 1.2 million taxpayers in Tax Year 2005 may have used hobby losses to reduce their taxable incomes to potentially avoid paying $2.8 billion in taxes.  Identifying and auditing additional individual returns that improperly deduct hobby losses could help to reduce noncompliance in this area.

This audit was initiated as a follow-up to the September 2007 TIGTA report to determine whether the IRS was maximizing opportunities to identify the most significant Schedule C, Profit or Loss From Business, noncompliance.  The overall objective of this review was to determine whether the IRS is taking sufficient action to minimize improper Schedule C losses claimed by taxpayers and the resulting loss of revenue to the Government.

TIGTA found that the IRS does not maximize the use of all relevant and available taxpayer information to identify hobby losses, and when returns containing potential hobby losses are selected for audit, the examiners do not always address the hobby loss issues. ...

TIGTA’s evaluation of IRS data from Processing Years 2011 through 2014 identified 9,699 individual returns from Tax Year 2013 that claimed a Schedule C loss of at least $20,000, gross receipts of $20,000 or less, and reported wages of at least $100,000. The taxpayers also reported losses in four consecutive years (Tax Years 2010 to 2013).

TIGTA’s review of a statistically valid sample of 100 returns determined that 88 returns (88 percent) showed an indication that the Schedule C businesses were not engaged in for profit. TIGTA estimates that 7,511 returns in the total sample population of taxpayers may have inappropriately used hobby loss expenses to reduce taxes by as much as $70.9 million for Tax Year 2013.

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As a former IRS tax compliance officer (and now attorney), this report is not at all surprising to me. Schedule C issues are often messy and continue to be “hot spots” for IRS audits.
What the TIGTA report does not tell us is whether taxpayers are purposely sheltering income or if they are simply unaware of hobby loss rules. Section 183 is simply not comprehendible by most taxpayers. To compound the issue further, I do not believe that most tax compliance officers and revenue agents understand how to apply Section 183 hobby loss rules. First, there is a misconception that if the taxpayer does not have profits in 3 out of 5 years, the business is not for profit. The truth is that the 3 out of 5 year rule is a presumption of profit. But not meeting the three out of 5 year rule is not a presumption of a hobby. The examiner needs to further develop the issue by applying the 9 factor test to determine whether there is profit motive. To complicate things even more, none of the 9 factors are more important than the other, and there is no magic number of factors that need to be met. As a result, hobby loss rules are potentially applied inconsistently and arbitrarily. There is simply too much subjectivity involved in making this decision. The only way to property apply this rule is to look at tax court cases to find similar fact scenarios and determine how the court applied Section 183 to the facts. IRS auditors do not have the skillset to be able to make such highly interpretative and complex decisions.
I do not believe the answer to TIGTA’s findings is to audit more Schedule C returns for the reasons mentioned above. The better solution is to revisit Section 183 and make it 1.) Easier for taxpayers to understand; and 2.) Simpler for the IRS to apply. Changes to tax laws as they apply to sole proprietors and single member LLCs are long overdue.

Posted by: taxguy | May 14, 2016 7:33:36 PM

With the recent case of "Roberts v. Commissioner" (CA 7, 4/10/ 2016 ) 117 AFTR 2d, the IRS will be even more challenged in recasting losing businesses as hobbies.

Posted by: carefornola | May 10, 2016 4:04:26 PM

This isn't so much a resource allocation issue (at least, not the way Michael W. believes) but a training issue. I deal regularly with auditors who have no idea what my clients do - and don't ask, either. They simply go the path of least resistance, without having a clue of what they should be looking for, because no one taught them how to properly do an audit. And yet Congress delights in cutting the budget year after year. No wonder morale at the IRS is at record lows.

Captain: the real issue is that the losses occur constantly, and leave one to wonder how the taxpayer can feed/clothe/house themselves with no income. And, as Chris said, are usually an MLM-type business.

Michael W. - being self-employed is not attractive to most employers. They look at you as someone who will leave at the first opportunity. I know - I've been on both sides of that equation.

Publius - No. A rational person would give up far sooner than 15 years if they haven't sold any books. Therefore, the likelihood is high that the 'business' is fraudulent. IMHO.

Posted by: taxlawyer | May 10, 2016 11:06:58 AM

Captain: Suppose you write travel guides. You've never sold any in the 15 years you've been doing it. Should you be able to deduct your twice annual "business trips" to Europe?

Posted by: Publius Novus | May 10, 2016 7:42:03 AM

Good comment Michael W. I wonder why Sch F was not included?

Posted by: Walt | May 9, 2016 12:22:30 PM

Yes, this is no doubt a resource allocation issue at the IRS. Beating up on conservative, low-tax, and pro-Israel groups has a higher priority there than these hobby v. business issues. In the last seven-plus years, we've seen the IRS adopt Chicago-machine politics toward their foes accompanied a near deafening silence in the press.

There is a factor to keep in mind though. I regularly tell people with less-than-stable jobs that they need their own business for a number of reasons:

1. When they're out of work, they can devote more time to it, possibly raising their income when they need money the most. At least they won't sit around, feeling worthless.

2. When applying for a job, current employment, even self-employment, looks better on a resume than being totally unemployed.

3. Eventually, that side business may become a full-time one, enabling them to leave that unstable job market forever.

4. After you retire, you can keep that part-time business going to beat the boredom.

Posted by: Michael W. Perry | May 9, 2016 8:38:46 AM

@Captain - I think the types of hobbies being looked at are "Amway" type activities that generate large tax losses and usually are not being run in any business like manner. However, given the resource issues at the IRS, I wouldn't expect too much of a change anytime soon.

Posted by: Chris | May 8, 2016 8:49:48 PM

Tax is not my area, so educate me. Maybe it's in the decisions. How would one distinguish an unprofitable business from a hobby? Suppose and individual has a full time wage and on the side he starts a business, and it is initially unprofitable, what result? Can't hobbies be a business? What about businesses that start from hobbies?

Posted by: Captain Hruska Carswell, Continuance King | May 8, 2016 2:16:23 PM

Dale is right. This is not a binary determination under current law. What TIGTA deems improper is, in the end, only that analyst's ex post subjective opinion regarding very difficult factors such as intent.

Posted by: Jack Manhire | May 8, 2016 1:38:02 PM

Good luck with this. Unless congress changes the law about intent, hobby losses are always going to be a leaky faucet. But, then again, intent is the key, isn’t it? After all, I’m guessing the early days of Apple were not profitable or run in a professional and business-like manner.

Posted by: Dale Spradling | May 8, 2016 11:26:36 AM