Taxpayers and the IRS often have differing views as to what constitutes a “trade or business.”
Take, for example, that moonshine you’ve been running out of the makeshift distillery in your basement. While you may think of this as your legitamate side business, the IRS is likely to disagree.
In fact, if the IRS sees a history of losses from an activity, they may well challenge whether the activity is truly a “hobby” rather than a trade or business. If successful, such a challenge would preclude a taxpayer from deducting a net loss from the activity, effectively rendering your moonshine-realted tax-benefits useless.
To help taxpayers and the IRS decide if an activity is entered into for profit or a hobby, the regulations under Section 183 (the so-called “hobby loss rules”), provide nine factors, which if answered in the affirmative, are indicative of a business.
1. The manner in which the taxpayer carries on the activity. Do they complete accurate books? Were records used to improve performance?
2. The expertise of the taxpayer or his advisers. Did the taxpayer study the activities business practices? Did they consult with experts?
3. The time and effort expended by the taxpayer in carrying on the activity. Do they devote much of their personal time and effort?
4. The expectation that the assets used in the activity may appreciate in value. Is the plan to generate profits through asset appreciation?
5. The success of the taxpayer in carrying on similar or dissimilar activities. Have they converting them from unprofitable to profitable?
6. The taxpayers history of income or losses with respect to the activity. Has the taxpayer become profitable in a reasonable amount of time?
7. The amount of occasional profits. Even a single year of profits can be a strong indication that an activity is not a hobby.
8. The financial status of the taxpayer. Does the taxpayer have other income sources that are being offset by the losses of the activity?
9. Does the activity lack elements of personal pleasure or recreation? If the activity has large personal elements it is indicative of a hobby.
Today, the Tax Court put these factors to use in Stromatt v. Commissioner, T.C. Summary Opinion 2011-42 (2011), holding that a taxpayers’ farming activity was an activity entered into for profit and the losses generated deductible in full.
What makes Stromatt unique is that you don’t often see farming activities as the subject of a Section 183 dispute; typically these cases focus on activities with a large recreational element, such as Amway distributorships and horse breeding.
Farming, it would seem, doesn’t posses these same elements. If I learned nothing else from Pauly Shore in Son-In-Law — and I didn’t — it’s that farming is arduous, backbreaking work; work that few rational humans would take on as a “hobby.”
The Court agreed, deciding factors #s 1,2, 3, 4, 6, and 9 in favor of the taxpayers. The court cited the substantial amount of physical labor and corresponding lack of recreational activities and disregarded the taxpayers history of losses, primarily because the IRS challenged the taxpayers’ losses a mere two years after the farming activity began, a particularly itchy trigger finger for a Section 183 challenge.
As with all Section 183 challenges, the fact that the taxpayers carried on their activity in a professional manner and kept accurate books and records was critical in the court’s decision in favor of the taxpayer.