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Archive for July 13th, 2011

As we’ve discussed in the past, the regulations provide nine factors under Section 183 that are used to determine whether a taxpayer’s activity is a “trade or business” or a “hobby.” If the activity is a trade or business, losses of the activity may be deducted in full and can offset other sources of income, subject to certain limitations. If the activity is a hobby, a taxpayer can only deduct losses to the extent of the income. 

The factors are:

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.

In a rarely seen run of failure, the taxpayer in Zensen v. Commissioner lost ALL NINE factors, leaving the Tax Court an easy decision in holding that the taxpayer’s drag racing activity was a hobby.

Full cite: Zensen v. Commissioner, T.C. Memo 2011-267.

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