[NOTE: Quotes below refer to "Schedule C losses". For those who do not know what those are: if an individual has their own business, they file the income and expenses of that business with the IRS using a Schedule C form; losses on that form can then be deducted from their overall income, reducing the amount of taxes they have to pay.]
Internal Revenue Code Section 183 (IRC 183) is sometimes referred to as the “Hobby Loss” part of the code because it deals with the very complex and murky subject of whether a taxpayer is engaging in a profit-driven business that also looks like a hobby or whether they are engaged in a hobby that they are trying to make look like a business in order to deduct costs.
It is so murky because the code is pretty much based on intent (whether a person is trying to make a profit) and--sharp objects aside--an auditor cannot get into the head of a taxpayer. The way tax courts have ruled on this matter has further complicated this matter for both taxpayers and auditors.
By being familiar with IRC 183, though, a person can take steps to make their businesses legitimate in the eyes of the IRS, even if they are taking substantial losses from something that some could argue is just a hobby.
First, a Discussion of the Code
It is worth noting that the code is a work in progress. The first version was created in 1943, in almost direct response to the actions of a man named Marhall Field. At the time, Field was operating two newspapers in Chicago as a sole proprietorship and taking a loss on them on his personal income taxes. Essentially, the Federal government was helping to subsidize his newspapers.
A large amount of litigation followed as the IRS tried to use the code to stop others from reducing their overall tax burden through loss-making side projects. The Tax Reform Act of 1969 was supposed to clarify how much a person could loose before they hand to stop: no more than $25,000 in 3 out of 5 years. A disagreement between the House and the Senate, though, killed putting a dollar amount on losses, resulting in a tax system that “defined profit as not only immediate economic profit but also any reasonably anticipated long term increase…" In other words, the IRS did not have the right to tell someone they were loosing too much money, provided that a profit might be seen at some point in the future.
In order to limit litigation over the now quite subjective rules about profit making, IRC 183 was put into place in 1988. The essential component was that any business which was profitable for 3 years out of a consecutive 5 year period would be considered a business, no matter how much it looked like a hobby. If the IRS wanted to pursue a case, the onus of proving that a business was really a hobby would fall on the IRS.
Today, IRC 183 is considered flawed by the Treasure Department. A recent review stated that “the IRS faces considerable challenges in administrating the tax law for taxpayers who take Schedule C losses year after year for potentially not-for-profit activities.” It said that current regulations “do not establish specific criteria for the IRS to use to determine whether a Schedule C loss is a legitimate business expense without conducting a full examination of an individual's books and records.” A full examination, of course, is a huge drain on IRS resources. According to the report, the IRS experimented with several cheaper methods of recovering money, including sending warning letters (which were often ignored) or doing audits by mail (which turned out to be nearly as time consuming and expensive, and which did not deter most taxpayers from taking losses in subsequent years).
The investigation made it clear that IRC 183 is not a “good tax” because it is so hard to enforce: “we conclude that it is difficult for the IRS to efficiently and effectively administer this provision.”
In its summation, the Treasure Department recommended that the legislation be changed to establish a clearly defined standard or “bright line rule” for determining whether a deduction is legitimate or not.
What the Code Means for Someone Who Turn a Travel Hobby Into a Business
1. According to the guidance the IRS publishes for auditors, “an activity could be considered a for-profit business if a taxpayer shows any profit during a 5 year period, even though larger losses are claimed in the other taxable years.” The safe harbor provided by IRC 183 helps protect the taxpayer. If a business takes three years of profit (which could technically be only a dollar in profit) and two years of heavy losses, the burden of proof still lies on the IRS to prove that it is not a for-profit business. An example of this might be taking a European vacation one summer, taking the cost of the trip as a business loss, and then selling a story ever year for the next three years, generating small profits in those years. The trip was an investment that paid off in the next few years with sold stories (which further your cause of turning your writing into a profitably business). You can do this provided that you “devote time to the business in the honest belief that the business will sometime in the future become profitable."
2. The IRS states: “It is not necessary for the taxpayer to show what their projected profit is expected to be.” Also, the IRS does not have the right to determine whether a business could be profitable, and a “reasonable expectation of profit” is NOT necessary. It is only important that the taxpayer is honestly trying to make a profit.
3. Although the code states that being profitable in 3 years out of 5 should alleviate most suspicion, it still allows a taxpayer to take losses year after year provided they can demonstrate that they are trying to make a profit. In one court case, a taxpayer took $700,000 in losses over seven years and the courts still ruled that he was conducting a for-profit business.
4. IRC 183 provides 9 considerations that an auditor should look at when determining whether a business is for-profit or a hobby loss. Those considerations will be looked in part II of this post.
In Summation
For now, the subjectivity and murkiness of the code is on the side of the taxpayer, particularly if the taxpayer shows three years of profit in a five year period. Provided that the taxpayer is conducting the business in the hopes of making a profit, even if the potential for profit is almost nonexistent, the current law sides with them and allows the loss, even if the loss is quite large and taken year after year after year.
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