Monthly Archive: January 2014

IRS Hobby Loss Rule

Submitted by Chris Moss CPA

Hobby Loss Rule

Millions of Americans start new business each year and become Sch C sole proprietors, small partnerships and single member LLCs. Some of these businesses almost immediately start making large profits. But an even larger number of businesses struggle for the first few years to develop market share among many competitors in their industry. Large losses are not uncommon for startup businesses sometimes for many years.

Lurking in the path to success for many of these new business owners is an overlooked aspect of tax law called the “hobby loss rule”. Simply stated: Section 183 of the United States Internal Revenue Code, sometimes referred to as the “hobby loss rule”, limits the losses that can be deducted from income which are attributable to hobbies and other not-for-profit activities. The IRS does not hesitate to reclassify as many of these business as they can to “hobby” status so that the losses cannot be deducted.

So when is a business not a business? Let’s take a look at an example of a typical new business audit from the IRS perspective:

In this example we will take Bill Jones who has always wanted to work on his own. Bill has been reading a lot about how home security is a profitable business and decides to take an early retirement as a government auditor and use his 401K money as seed capital until he gets his business up and running. He realizes he will be taxed heavily and will be penalized as he liquidates his 401K, but his brother in law Joe who is a bookkeeper tells him that not to worry, he will be able to deduct losses in connection with his business against the 401K income as well as his wife’s W2 income so there will be no tax as a result and a large refund due his wife when the tax return is filed.

Fast forward a few years, and Bill has not been able to turn a profit yet. Bill works 40 per week trying to market and develop the Security for Life brand and to service his growing customer bases. But he also spends a lot of his time helping with the two children as his wife works full time as a salaried executive. Just when Bill gets a big new contract providing security for new home construction with a local builder, he gets the IRS field audit notice. He panics and calls his brother in law Joe. Joe refers him to a CPA. After the CPA reviews the whole situation he tells Bill the following

The audit most likely is going to focus on whether or not there is sufficient profit motive to deduct the losses each year. Bill is further told about Section 1.183-2(b) of the Income Tax Regulations which lists 9 factors to be considered in determining whether an activity is engaged in for profit of which the first three in my view are most important:

(1) manner in which the taxpayer carries on the activity;
(2) expertise of the taxpayer or his advisers;
(3) time and effort expended by the taxpayer in carrying on the activity;

Bill at first feels great. He clearly works full time and works at least 40 hours a week. But the CPA is not feeling so well because the CPA believes Bill loses on (1) and (3). Regarding the manner in which Bill carries on his business the facts show that Bill has not no separate office out of the home and uses a personal phone number for his business phone. Bill did not obtain a county business license because it would have been too much trouble to get a home use occupation zoning exception. His checking account was not separate and distinct from his personal accounts. Even Bill’s internet service was a “personal” rather than a business account. Furthermore, Bill had no formal training in home security. Bill read lots of books and registered for many internet training sessions, but he never worked for a home security company. He refused to joint venture with a competitor, and refused to trademark his brand “Security for Life”. Bill told the CPA he simply was trying to save money and all these things cost too much including the hiring of a professional tax attorney or CPA.

Fastforward a few more months. In fact the IRS audit did not go well for Bill. The Service claimed that Bill used the business as a “ tax shelter” for his wife’s income. The IRS disallowed all the losses over a 3 year period with a tax assessment of over $20,000 plus interest and penalties.

Bill can appeal this decision. Whether or not he wins simply depends on whether the facts in his unique case are supported by tax law, and how skilled his tax attorney is in advocating Joe’s case before the US Tax Court. His legal costs can easily run over $50K. Bill could not afford to appeal the decision so he paid the tax, penalties and interest, well over $20k. The take away here for all small business owners is to make sure you run the business like a business. If your not sure, hire the pros who could help you make your business bulletproof from IRS audit. If you don’t you may be considered by the IRS a hobby. In the meantime, work hard, grow your small business and prosper and by all means, please make a profit soon.

Kindest regards from Chris Moss CPA