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Aside from Amway dealerships, the most frequently challenged activities under the  “hobby loss” provisions of Section 183 are horse breeding and drag racing. So when a family does both — deducting big losses from each activity — they’re almost begging to wind up in front of the Tax Court.

In Ryberg v. Commissioner, husband and wife — who were both gainfully employed with 9-5 jobs — also jointly operated a horse breeding activity. In what little time he had left, husband would race. Both activities had generated substantial losses since their inception. Illustrating the thin line between business and hobby, the Tax Court held that the horse breeding activity was entered into for profit, while husband’s drag racing activity was not.

As a reminder, the hobby loss rules exist for the sole purpose of determining whether a taxpayer’s activity is a “activity entered into for profit” or a “hobby.” If the activity is the former, 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, however,  a taxpayer can only deduct losses to the extent of the income; they cannot create a tax loss.

The regulations established — and the courts routinely examine — nine factors to be used in determining whether a particular activity is entered into for profit or a hobby:

1. The manner in which the taxpayer carries on the activity;  2. The expertise of the taxpayer or his advisers; 3. The time and effort expended by the taxpayer in carrying on the activity; 4. The expectation that the assets used in the activity may appreciate in value; 5. The success of the taxpayer in carrying on similar or dissimilar activities; 6. The taxpayers history of income or losses with respect to the activity; 7. The amount of occasional profits; 8. The financial status of the taxpayer; and 9.  Whether the activity lack elements of  personal pleasure or recreation. 

In reaching its split decision in Ryberg, the court analyzed each activity in accordance with the regulations, highlighting the following factors:

Horse Breeding Activity = Activity Entered Into for Profit

  • Carried on the activity in a  businesslike manner, conducting market research before start-up, educating themselves on the business and economic aspects of the activity, drafting formal breeding contracts, and extensively advertising and publicizing their services.
  • Kept accurate books and records on a monthly basis, and maintained a separate charge account
  • Developed extensive expertise in horse breeding and studied the business and economic side of the business; utilized the knowledge to cut costs.
  • Changed operating methods and adopted new technique with the intent of improving profitability.
  • Consulted with other business owners regarding the profitability of adding horse boarding.
  • Did not ride the horses for pleasure
  • Abandoned the horse breeding operations in 2007 when they finally determined they could not turn a profit.

Based on these factors, the court concluded that the horse breeding activity was entered into for profit, notwithstanding the history of losses from 1998-2006, as this represented the “startup phase” of the activity.

Drag Racing = Hobby

  • Failed to provide a copy of a spreadsheet or any document used to track expenses.
  • Did not provide any books or records to document race winnings or sponsorship money.
  • Sought advice to improve racing skills, not profitability.
  • Did not study or build a particular expertise in the business aspects of drag racing.
  • Even in his best racing season, he could not turn a profit because of the large amount of expenses attributable to the activity.
  • High elements of personal pleasure.

In addition to the above, the Tax Court concluded that the history of continuous losses from 1990-present was too much to overcome, as a twenty year time span far exceeded any reasonable startup time. Thus, the drag racing activity was held to be a hobby, with expense only allowable to the extent of its income.

We’ve said it again but it bears repeating; if you want your activity to be respected as a business, you have to treat it like one. Keep detailed books and records, and USE those records to make changes to your busienss in an attempt to drive profits. Garner expertise: take classes, consult with other profesionals in the industry, and constantly go back to the drawing board if things aren’t working out. Lastly, keep the personal pleasure to a minimum, and if all else fails, quit.

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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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