Sunday, September 20, 2009

Hobby Losses: Safe Harbor Presumption.

When the IRS seeks to limit deductions for businesses reclassified as hobbies, it will look to nine factors listed in the Treasury Regulations. These factors are used to weigh the facts and circumstances that indicate a profit motive or lack thereof.

Before discussing the factors, it is important to note that the hobby loss rules are subject to a presumption that an activity is a business if certain requirements are met. If an activity turns a profit in 3 of 5 consecutive years, the activity is presumed to be a business. If so, the business is presumed to be allowed to deduct expenses beyond the amount of income from the activity and the losses can offset other income on a tax return. The calculation of the presumptions period begins with the first profitable year of the business.

When dealing with activities related to the breeding, training, showing or racing of horses, the presumption only requires a profit in 2 of 7 consecutive years.

It should be noted that meeting these requirements only creates a presumption. In an audit the IRS can work to rebut the presumption and may still be able to prove that the business should be classified as a hobby. In this analysis, the IRS will consider whether income and expenses have been manipulated to avoid application of the hobby loss rules. For example, the IRS is likely to raise the hobby issue in spite of the presumption if the activity shows only minor profits in 3 of 5 years but substantial losses in the other 2 years if those losses considerably outweigh the profits in the other 3 years.

No comments: