IRS often examines tax returns with losses from trade or profession (Schedule C) to determine the legitimacy of the claimed loss. If they decide it is not an activity entered into to make a profit, they will classify it as a hobby loss. The consequence being to disallow the loss and assess additional income taxes.
As a taxpayer representative you may be called on to defend the loss. If the loss has offset income from wages or other source the taxable income will increase for the year under examination, but that is not where the problem ends. Typically, the Revenue Agent will review prior returns to see if the adjustment might be appropriate in those earlier (or later) years. By the end of the process a $3,000 adjustment in one year might grow to $10,000. To make it worse, the taxpayer may fault the preparer for not properly advising about this potential problem – even if they were advised.
There is a safe-harbor rule that an activity that earns a profit in three of the five years IRS presumes that activity is profit motivated. Note that the two in five rule changes to two in seven for activities that involve horses. For example, racing, breeding, training, or show activities.
Under Internal Revenue Code Section 183(e) a taxpayer may elect to postpone the determination of hobby loss during a test period. The test period lasts five years, or seven years for horse activities. Making the election automatically provides the IRS two more to assess a deficiency until two years after the date for filing the return for the last year of the presumption test period.
The Section 183 deductions and related items are subject to the extended assessment period plus items that depend on adjusted gross income and might be affected if the Section 183 deductions are disallowed.
To make the election use form 5213, titled Election to Postpone Determination as to Whether the Presumption Applies That an Activity Is Engaged in for Profit. On the plus side, filing the election allows additional time to establish a profit motive. On the negative side, it may bring the IRS’s attention to the potential hobby loss question. It is advisable to only file the election if the IRS has notified the taxpayer that they propose to disallow the loss that the taxpayer believes is a bona fide business.
If the safe-harbor rule does not apply to your taxpayer, the IRS is supposed to then move to making the determination based on facts and circumstances. Therefore, it is not the case that failing the safe-harbor rules means the business automatically presumed to be a hobby. Occasionally IRS auditors will try to use the safe-harbor test to the taxpayer’s detriment by contending that failing the test means it is a hobby. In that instance, you must then force the issue to be considered based on facts and circumstances. If the auditor is uncooperative, and their supervisor does not supersede the auditor’s position, request an appeals hearing or perhaps fast-track mediation. If the mediation fails to achieve your desired result, you can then proceed to Appeals.
Larry Lawler, CPA, EA, CTRS, NTPI Fellow
Larry is the National Director of the American Society of Tax Problem Solvers (ASTPS). He has represented literally thousands of taxpayers before the Internal Revenue Service and is a frequent public speaker, a writer on professional topics, and a regular trainer of tax professionals nationwide. He has been a New York Certified Public Accountant since 1973. He is also a fellow of the National Tax Practice Institute. Larry is the managing partner of Lawler & Witkowski, CPAs, PC, the firm he established in 1973.