The Internal Revenue Code
restricts taxpayers from deducting expenses for activities that are not
engaged in for profit. These are commonly referred to as "hobby
The IRS in 2007 posted on
the IRS.GOV website a fact sheet that discusses the classification of an
activity as one having a profit motive, or one that is an activity not
engaged in for profit. They also address the deduction of expenses
related to the hobby. This fact sheet is reprinted below:
Business or Hobby? Answer Has Implications for Deductions
FS-2007-18, April 2007
The Internal Revenue Service
reminds taxpayers to follow appropriate guidelines when
determining whether an activity is a business or a
hobby, an activity not engaged in for profit.
In order to educate taxpayers
regarding their filing obligations, this fact sheet, the
eleventh in a series, explains the rules for determining
if an activity qualifies as a business and what
limitations apply if the activity is not a business.
Incorrect deduction of hobby expenses account for a
portion of the overstated adjustments, deductions,
exemptions and credits that add up to $30 billion per
year in unpaid taxes, according to IRS estimates.
In general, taxpayers may deduct
ordinary and necessary expenses for conducting a trade
or business. An ordinary expense is an expense that is
common and accepted in the taxpayer’s trade or business.
A necessary expense is one that is appropriate for the
business. Generally, an activity qualifies as a business
if it is carried on with the reasonable expectation of
earning a profit.
In order to make this
determination, taxpayers should consider the following
Does the time and effort
put into the activity indicate an intention to
make a profit?
Does the taxpayer depend
on income from the activity?
If there are losses, are
they due to circumstances beyond the taxpayer’s
control or did they occur in the start-up phase
of the business?
Has the taxpayer changed
methods of operation to improve profitability?
Does the taxpayer or
his/her advisors have the knowledge needed to
carry on the activity as a successful business?
Has the taxpayer made a
profit in similar activities in the past?
Does the activity make a
profit in some years?
Can the taxpayer expect to
make a profit in the future from the
appreciation of assets used in the activity?
The IRS presumes that an activity
is carried on for profit if it makes a profit during at
least three of the last five tax years, including the
current year — at least two of the last seven years for
activities that consist primarily of breeding, showing,
training or racing horses.
If an activity is not for profit,
losses from that activity may not be used to offset
other income. An activity produces a loss when related
expenses exceed income. The limit on not-for-profit
losses applies to individuals, partnerships, estates,
trusts, and S corporations. It does not apply to
corporations other than S corporations.
Deductions for hobby activities
are claimed as itemized deductions on Schedule A (Form
1040). These deductions must be taken in the following
order and only to the extent stated in each of three
Deductions that a taxpayer
may take for personal as well as business
activities, such as home mortgage interest and
taxes, may be taken in full.
Deductions that don’t
result in an adjustment to basis, such as
advertising, insurance premiums and wages, may
be taken next, to the extent gross income for
the activity is more than the deductions from
the first category.
Business deductions that
reduce the basis of property, such as
depreciation and amortization, are taken last,
but only to the extent gross income for the
activity is more than the deductions taken in
the first two categories.
The Internal Revenue Code
Section 183 provides a presumption of profit for activities as follows:
If the gross income derived from an activity
for 3 or more of the taxable years in the period of 5 consecutive
taxable years which ends with the taxable year exceeds the
deductions attributable to such activity (determined without regard
to whether or not such activity is engaged in for profit), then,
unless the Secretary establishes to the contrary, such activity
shall be presumed for purposes of this chapter for such taxable year
to be an activity engaged in for profit.
In the case of an activity which consists in
major part of the breeding, training, showing, or racing of horses,
the preceding sentence shall be applied by substituting ''2'' for
''3'' and ''7'' for ''5''.
The rule is clear - show a
profit in 3 out of 5 consecutive years (2 out of 7 for breeding, etc.)
and the IRS must PROVE that you are NOT in the business of making a
profit. If you do NOT meet this test, it does NOT mean you are
presumed to be in the activity for other than a profit motive!
It means that you must rely on other factors (not the presumption)
to persuade the IRS or a Court that you have a profit motive.
Following is a synopsis from a
2005 Tax Court case that
discusses the disallowance of a loss claimed by a dentist for his horse
breeding and showing activity. Pay particular attention to the
factors that the Court considered as evidence of the taxpayer's lack of
Code Section 183—Activities not-for-profit—horse
breeding and showing—proof.
Dentist didn't engage in horse breeding and showing activities for
profit: taxpayer didn't keep separate accounts or business-like records
for activity, didn't operate it comparable to other profitable horse
businesses, didn't try to change her operational methods to correct
14-year loss history, and didn't otherwise show that she carried on
activity in valid business-like manner. Also telling were facts that
taxpayer never gained expertise in horse activity and its peculiar
economics, maintained fulltime dental practice while engaged in
activity, didn't show any real appreciation in value of any of her
horses or horse assets save one, used activity losses to offset
significant income from her dental practice and investments, and drew
personal pleasure from activity. (Elizabeth Giles v. Commissioner,
(2005) TC Memo 2005-28)
Here is a synopsis of a 2007 Tax Court case involving the IRS's
determination that an activity was not engaged in for profit.
You can see what factors the Court considered as relevant in making its determination:
Code Section 183—Activities not-for-profit—horse-boarding—profit
motive—bona fide business.
Sales manager/executive's and wife's for-profit
treatment of loss-generating horse-boarding activity was upheld:
taxpayers conducted activity with actual profit intent as bona fide
business activity within meaning of Code Sec. 183 and Code Sec. 162 .
Although taxpayers admitted that, after following carefully modified
business plan, they realized they would never make profit, such didn't
in itself reflect lack of profit objective and was outweighed by overall
evidence that they had kept meticulous records and accounts, kept
operating in business-like manner until they could sell, and took steps
to mitigate costs and to try and at least break even. Also, taxpayers'
prior experience in owning horses well-qualified them for horse-boarding
business; husband spent substantial time on such despite living hours
from boarding facility; his executive management position salary wasn't
so high as to easily absorb boarding losses; and taxpayers didn't derive
substantial personal pleasure from boarding. (Michael J. Rozzano, Jr.,
et ux. v. Commissioner, (2007) TC Memo 2007-177
Here is a 2012 Court
Case involving horse breeding:
Code Section 183—Activities not-for-profit—horse breeding, training
and sales—profit motive—proof—deductions.
Horse breeding activity engaged in by
homemaker, who held consumer finance degree and real estate license,
and her attorney-husband was activity not engaged in for profit
within meaning of Code Sec. 183 : overall facts and circumstances
showed that instead of holding actual and honest profit objective,
taxpayers engaged in activity as hobby. Factors included that
despite “hemorrhaging losses” and determining that they needed to
acquire their own horse facility rather than pay to board elsewhere
in order to control costs and improve profitability, taxpayers
waited years before even buying land on which to construct their own
facility and otherwise failed to conduct activity in businesslike
manner. Other factors included that activity had sustained losses
which taxpayers used to offset significant income from husband's law
business. Also, allegation that taxpayers' move to new area that was
more hospitable to horse activity showed intent to pursue same as
business was unpersuasive when considering above plus fact that new
area could have been equally welcoming to horse enthusiasts as to
bona fide breeders. (Peter C. Bronson, et ux. v. Commissioner,
(2012) TC Memo 2012-17)