Internal Revenue Code Section 183 limits the deductibility of expenses where the activity is determined to be a hobby instead of a business. These limitations prohibit a person from claiming losses from the hobby that exceeds the income from the activity. That is, a hobby cannot generate losses that offset other income on a tax return.
The reason that the hobby loss rules exist is to address the concern that taxpayers with substantial income from other sources will attempt to reduce their taxable income by engaging in an activity simply to generate losses that offset that income. For example, perhaps someone with substantial financial resources enjoys auto racing and spends a lot of money on the activity. The auto racing activity has no realistic possibility of turning a profit. That taxpayer might call the activity a business and attempt to reduce his substantial income (by claiming losses) and pay less tax.
The Treasury Inspector General for Tax Administration wrote in its 2007 report that approximately 1.5 million taxpayers filed a Schedule C with their tax returns showing only losses over the four year period 2002-2005. The report states that by claiming the losses, these taxpayers avoided paying roughly $28 billion in taxes in the year 2005 alone. This would seem to validate the IRS’ concern and likely explains the apparent increase in the number of hobby loss audits.
Unfortunately, in applying the hobby loss rules, some auditors seem to look past the basic reason for the hobby loss rules. By this I mean that the hobby loss rules are being applied against taxpayers without substantial income from other sources and to those that are not offsetting their taxable income by any meaningful amount. This means that even the proverbial “little guy” is getting caught up in hobby loss audits. Unfortunately, the way that the hobby loss rules are written allows this to happen. Later posts to this blog will discuss the hobby loss rules, an understanding of which can help a business owner dispute a hobby loss audit.
The reason that the hobby loss rules exist is to address the concern that taxpayers with substantial income from other sources will attempt to reduce their taxable income by engaging in an activity simply to generate losses that offset that income. For example, perhaps someone with substantial financial resources enjoys auto racing and spends a lot of money on the activity. The auto racing activity has no realistic possibility of turning a profit. That taxpayer might call the activity a business and attempt to reduce his substantial income (by claiming losses) and pay less tax.
The Treasury Inspector General for Tax Administration wrote in its 2007 report that approximately 1.5 million taxpayers filed a Schedule C with their tax returns showing only losses over the four year period 2002-2005. The report states that by claiming the losses, these taxpayers avoided paying roughly $28 billion in taxes in the year 2005 alone. This would seem to validate the IRS’ concern and likely explains the apparent increase in the number of hobby loss audits.
Unfortunately, in applying the hobby loss rules, some auditors seem to look past the basic reason for the hobby loss rules. By this I mean that the hobby loss rules are being applied against taxpayers without substantial income from other sources and to those that are not offsetting their taxable income by any meaningful amount. This means that even the proverbial “little guy” is getting caught up in hobby loss audits. Unfortunately, the way that the hobby loss rules are written allows this to happen. Later posts to this blog will discuss the hobby loss rules, an understanding of which can help a business owner dispute a hobby loss audit.
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