The IRS is always on the lookout for taxpayers that engage in activities which reduce their income from other sources. You might say that such activities are a “red flag” for an IRS audit. It is up to the IRS examiner to make a factual determination as to whether an activity is engaged in for profit such that losses from the activity are deductible. As you may guess, the IRS often denies such deductions.
With respect to your [insert taxpayer activity], it is up to you to prove that the activity is engaged in with an actual and honest objective of realizing a profit. When an activity is not engaged in for profit, the “hobby loss” rule applies to disallow any loss from the activity. In this case, you can only deduct expenses from the activity to the extent of the gross income it derives from the activity. In such a case, the expenses from the activity must be applied in a specific order to offset the gross income of the activity.
The following is a list of factors that the IRS and courts consider in determining whether your activity is engaged in for profit and, thus, if any loss from the activity is deductible:
(1) the manner in which you carry on the activity (e.g. maintaining complete and accurate books and records);
(2) your expertise in the area or the expertise of advisers (e.g., preparing for an activity by extensively studying its accepted business, economic, and scientific practices, or by consulting with advisers who are experts in such practices);
(3) the time and effort put into the activity (e.g., withdrawing from other activities to concentrate on the activity at hand);
(4) the expectation of appreciation in the assets used in the activity;
(6) the history of income and losses from the activity (e.g., a series of profitable years versus a series of unprofitable years);
(7) comparing profits to other measures (e.g., the amount of investment in the activity);
(8) your financial status (e.g., whether losses generate significant tax benefits); and
(9) the presence of any personal motives in carrying on the activity (e.g., where an activity has substantial recreational or personal elements).
An activity generally is presumed to be engaged in for profit for a tax year if the activity generates a profit for any three of the five consecutive tax years ending with the current tax year. An activity that consists primarily of breeding, training, showing, or racing horses is presumed to be engaged in for profit if the activity generates a profit for any two of the seven consecutive tax years ending with the current tax year.
In order for us to properly document that your business activity is engaged in for profit, we should meet to discuss the factors above.
Please contact the office of Don Fitch Accountancy at (760)567-3110 or Email Don.Fitch@CPA.com if you have any questions or would like additional information.
DON FITCH, CPA
74478 Highway 111 #3
Palm Desert, CA 92260
Toll Free: (877)CPA-Help or (877)272-4357
P.S. My firm is based upon referrals. Please feel free to refer my firm to anyone you know that is looking for a new CPA and/or tax preparer. Thank you in advance.
(Updated 04072021 DFA 320-360)