Business or Hobby?

The difference between a business and a hobby can be tricky. According to the Internal Revenue Code, a taxpayer is allowed to deduct business losses in excess of income on his personal tax return. Hobby losses can be deducted only to the extent of the hobby income, and only as an itemized deduction on Schedule A of the 1040. A Tax Court memorandum was just filed which distinctly shows the difference between a business and a hobby. The case Michael G. Judah and Sally A. Judah v. Commissioner of Internal Revenue concerns a saddlebred horse activity engaged in by the Judahs. The activity consisted mainly of promoting their daughter as a saddlebred horse rider, buying and selling horses, and various other activities.  The Judah’s reported this activity as a business and over 14 years (1998-2012), they reported nearly $1.5 Million in losses and did not earn a profit in any single year. The Judah’s took these losses against their profitable real estate businesses thus saving them hundreds of thousands of dollars in taxes. The Judah’s claimed that their horse business should be combined with their real estate business because their horse business allows them to network with well-to-do potential clients.

According to the Internal Revenue Code Section 183(d), the IRS defines a business or “activity engaged in for profit” as “the gross income derived from an activity for 3 or more of the taxable years in the period of 5 consecutive taxable years which ends with the taxable year exceeds the deductions attributable to such activity”. The IRC has a special rule for horse activities. If the activity “consists in major part of the breeding, training, showing, or racing of horses”, then the activity only has to be profitable in 2 out of 7 years.  If the activity cannot meet this definition, the taxpayer must establish that the activity has a profit motive.

The IRS decided that the Judah’s horse activity was not a business and disallowed their losses in an audit for the years 2008 to 2010. Consequently, the IRS determined that the Judah’s owed $136,800 in back taxes as well as $27,378 in penalties. The Judah’s went to Tax Court to see if they could get these taxes and penalties eliminated.  The Tax Court decided that the Judah’s Real Estate business was separate from their horse activity based on a number factors, but mainly that the two activities did not share land, management, caretakers, or even the same accountant. Since the Judah’s horse activities had never been profitable, the Tax Court had to determine if there was a profit motive. The factors used by the Tax Court are outlined below.

1)      The Manner in Which the Taxpayer Carries On the Activity

The Tax Court was looking to see if the saddlebred activity was carried out in a business manner. The court outlined five considerations in making this determination.

A)    Whether the Judah’s maintained complete and accurate books and records for the activity.

B)    Whether the taxpayer conducted the activity in a manner substantially similar to comparable activities that were profitable.

C)     Whether the taxpayer changed operating procedures, adopted new techniques, or abandoned unprofitable methods in a manner consistent with an intent to improve profitability.

D)    The preparation of a business plan.

E)     In the case of horse breeding and sales, a consistent and concentrated advertising program.  

The Tax Court ruled that the only factor the Judah’s met of those five was that they did advertise their activity. But that was not enough, the court ruled that the Judah’s did not carry out their activity in a business manner.  

2)      Expertise of the Taxpayer

For this factor to be ruled in the Judah’s favor, the Tax Court must find that the Judah’s consulted experts as to the how to run their business in a profitable manner. The Tax Court found that since the Judah’s did consult with horse trainers on the best ways to sell their horses. This factor was ruled in their favor.

3)      Time and Effort Allocated to Activity

The Tax Court found that the Judah’s did not spend the time or effort to establish that they had the objective of making a profit. The Judah’s spent most of their time on the enjoyable aspects of the saddlebred horse activity and none of the nitty-gritty aspects of running a legitimate saddlebred horse business.

4)      The Expectation That Assets Used in the Activity May Appreciate in Value

Sec. 1.183-2(b)(4) of the Income Tax Regs. states that a profit motive may be indicated if there is an expectation that the assets used in the activity will appreciate in value. However, the Tax Court has previously ruled that a profit objective is inferred when the expected appreciation of the assets is sufficient to recoup the accumulated losses of prior years. From 1998-2012, the Judahs had combined losses of nearly $1.5 Million. The Judah’s conceded that they would never generate enough profit to recoup the $1.5 Million in losses. This factor was ruled in favor of the IRS.

5)      Success of Taxpayer in Carrying on Other Related Businesses

The Tax Court looked to see whether the Judah’s had ever engaged in any similar businesses and turned them from unprofitable to profitable. The Judah’s had never engaged in any similar businesses. Therefore, this factor had no effect on their case.

6)      The Taxpayer’s History of Income or Loss With Respect to the Activity

Although a business in the initial or startup stage can be expected to generate losses, the Judah’s record of 14 years of losses was persuasive evidence that the taxpayer did not have a profit motive.

7)      The Amount of Occasional Profits Earned

Per Sec. 1.183-2(b)(4) of the Income Tax Regs., the amounts of profits in relation to the amount of losses incurred may provide evidence of the taxpayer’s intent. The Judah’s saddlebred activity has never had a profitable year. The fact that the Judah’s engage in this activity despite the fact that they continue to lose money gives the impression that there is an ulterior motive other than profit.

 

8)      The Financial Status of the Taxpayer

The Judah’s had substantial income from their Real Estate businesses. A taxpayer who has substantial income from a source other than the activity could indicate that the taxpayer is not engaged in the activity for profit. The Judah’s were able to offset their substantial income with losses from the saddlebred activity. Because the Judah’s wanted to promote their daughter as a saddlebred rider, it’s likely that the Judah’s would have incurred much of these expenses anyway. This factor was ruled in favor of the IRS.

 

9)      Whether Elements of Personal Pleasure or Recreation are involved

 

Sec. 1.183-2(b)(9) of the Income Tax Regs. states that the presence of personal motives and recreational elements in carrying on an activity may indicate that the activity is not engaged in for profit. The Judahs avoided all the unpleasant aspects of saddlebred activity such as cleaning stalls or feeding the horses. Their work consisted of the pleasurable parts of the activity, mainly watching their daughter ride horses.

 

Conclusion

 

The tax court concluded that the Judahs operated their saddlebred horse activity as a hobby not a business. Therefore the Judah’s owed $136,800 in back taxes for years 2008-2010. The Judah’s did have a minor victory in this decision. The CPA who prepared the returns had advised the Judah’s that the saddlebred horse activity was a business. Because the Judah’s took the business deductions “in good faith” based on their CPA’s opinion, they were not held liable for the $27,378 in accuracy-related penalties that the IRS was seeking.

A taxpayer who does not meet the 3 years out of 5 rule but still believes his activity is a business should take a look at the factors above to determine if their activity is indeed a business. The Judahs learned the hard way about the difference between a business and a hobby and it cost them big.