Determining whether an activity is a trade or business under section 162 or a hobby under section 183 can be difficult due to the fact-intensive nature of the inquiry. Section 183(b) limits deductions for hobby activities that lack a profit motive to income and gains from the activity.1 The related regulations lay out nine non-exclusive factors to be weighed in making the “facts and circumstances” determination.2 The Tax Court’s recent decision in Joy Ford v. Commissionercame to the familiar conclusion that the taxpayer lacked a profit motive because the taxpayer could not provide adequate evidence of a trade or business.3
The taxpayer purchased a music venue with the hopes that it would draw aspiring country music singers. Taxpayer had been in the business of a music promoter and hoped to translate that skillset into running a successful performance venue. The venue was purchased for $500,000 and only a few years later had appreciated significantly in value. The appreciation alone was not enough for the Tax Court to find for the taxpayer.
Failure to maintain written records, lack of expertise, ignoring business advice, continuing to operate despite continued losses, the financial status of the taxpayer, and the personal pleasure the taxpayer derived from the activity all were important negative factors for the court.4 The court paid particular attention to how the taxpayer “nonchalantly accepted Bell Cove’s perpetual losses, and made no attempt to reduce expenses.”5 Worsening the situation was the fact that Bell Cove’s losses increased each year: the taxpayer paid artists flat fees despite rarely ever making enough from the performances to cover the payments.6
Commingling funds or paying for expenses out of a personal bank account and not keeping proper records is an important factor for courts.7 There are several cases in which the Tax Court denied taxpayer claims because a true business would have separate accounts with formal documentation of its transactions.8 From the IRS’ perspective, reasonable taxpayers will not be involved in an activity that creates substantial losses and lacks proper business records unless the taxpayer is not actually engaged in a real business but merely willing to incur losses (especially if those losses can be used to offset other income).
Making a profit is a critical objective for running a business. Although the regulations allow for losses initially (especially if there are unforeseen circumstances), the IRS wants to make sure the taxpayer is not merely using a personal activity’s costs to mask income in other areas.9 In order to show a profit motive despite losses taxpayers need to demonstrate activity that supports a genuine profit motive, such as seeking business advice to help stem losses.10 In this case, in which the taxpayer allowed losses to increase and ignored business advice from experts, it is much less likely that either the IRS or the courts will find a profit motive.
The Tax Court noted that the venue’s substantial appreciation in value was not sufficient to convince it to find for the taxpayer.11 The taxpayer claimed to be in the business of running a performance venue, not merely investing in property with hopes of gains in the investment from appreciation. Cumulative operating losses were more indicative of the taxpayer’s motive than the appreciation in the venue property.
The regulations also look to the financial status of the taxpayer. In this instance the taxpayer had significant trust income.12 Significant income from other areas requires closer scrutiny of the various factors indicating a hobby activity. Taxpayers lacking other sources of income are more likely to be involved with a trade or business than those who participate in an activity in their spare time and can afford continuous losses.
Taxpayers tend to forget that the burden of proof is on them when claiming deductions, so adequate written record keeping, proof of a written business plan, evidence of adequate research about the new business, and solicitation of advice from experts (as well as following that advice at least in part) can make the difference.
Sections 183 and 199A
The 2017 tax legislation enacted a new section 199A deduction for pass-through entities. This can be particularly beneficial for taxpayers who have side businesses in the form of sole proprietorships, but may raise some of the same questions as the analysis under section 183. Had the taxpayer in the above case succeeded in showing that her operation of Bell Cove was a trade or business, she also could—once she started having business profits--take advantage of section 199A’s deduction to reduce her taxable income.
Because the 2017 tax legislation is so new, the Secretary has yet to write regulations on anti-abuse rules and certain definitions relevant to section 199A. This will cause considerable uncertainty for those taxpayers who wish to take advantage of the deduction unless either notices or proposed regulations are forthcoming before year-end.13
In general, section 199A allows taxpayers other than corporations to take a deduction based on their “qualified business income.” While the details are rather complicated, the provision essentially entitles eligible taxpayers to a deduction equal to 20% of their qualified business income.14 For taxpayers above certain income thresholds,15 the deduction is limited to the greater of (i) 50% of their W-2 wages or (ii) 25% of their W-2 wages and 2.5% of the original unadjusted bases in qualified properties (generally, depreciable tangible property held by or for use in the qualified trade or business and used during the year to produce qualified business income).16 This wages-or wages plus capital-limitation would apparently adversely affect a pass-through company engaged in employee leasing in which the company is not responsible for the W-2 wage payments and holds little business property.
Unfortunately for “specified service trade or business” taxpayers, section 199A is not available once those same income thresholds are exceeded.17 This includes trades or businesses described in section 1202(e)(3)(A) and those services that consist of investing, managing, trading, or dealing in securities.18 Interestingly, engineering and architecture were excluded from the disallowance (but not doctors and lawyers).19
Qualified business income includes net income from the active conduct of a trade or business, but excludes investment income.20 Dividends (constructive included) to S-Corporation shareholders or partners are not included in this definition either.21 Reasonable compensation and guaranteed payments to partners for services rendered for the partnership are not counted.22 As an example, if a partner is allocated $100,000 for the year, of which $30,000 was a guaranteed payment, only $70,000 would be eligible for the percentage deduction.
Similar to the hobby loss limitations, taxpayers must make sure that the income they claim as eligible for the section 199A deduction is from an eligible actively conducted trade or business and not a passive investment or hobby activity. This provision does offer a valuable deduction for taxpayers who operate as flow-through entities with expensive employee payrolls and/or considerable qualified business property.
On the other hand, taxpayers who fail to satisfy the trade or business test for using their losses will also be out of luck for taking advantage of the section 199A deduction when they have income. If the IRS challenges the legitimacy of a trade or business on audit and succeeds, the taxpayer will have more taxable income than originally reported. While this new provision provides a generous tax subsidy for entrepreneurs, taxpayers should be aware of the consequences of how they set up and conduct their trades or businesses so that they avoid the “hobby” designation and can be treated as generating “qualified business income.” ■
1 I.R.C. § 183(b).
2 Treas. Reg. § 1.183-2(b).
3 Ford v. Comm'r, T.C. Memo 2018-8 6, 2018 Tax Ct. Memo LEXIS 9, *4-5.
4 Ford v. Comm'r, T.C. Memo 2018-8 5, 2018 Tax Ct. Memo LEXIS 9, *4.
5 Id.
6 Ford v. Comm'r, T.C. Memo 2018-8, 3, 2018 Tax Ct. Memo LEXIS 9, *2,
7 Treas. Reg. § 1.183-2(b)(1).
8 See, e.g., Long v. Comm'r, 2016 Tax Ct. Summary LEXIS 90, *16, T.C. Summary Opinion 2016-88 (T.C. Dec. 20, 2016) (“Petitioner did not maintain complete and accurate books and records. Petitioner has not asserted he had a business plan or an accounting system for his business, and his recordkeeping was incomplete and disorganized. To substantiate expenses petitioner provided minimal receipts (some of them incomplete), credit card summaries with handwritten notes, and bank statements from his personal bank account. Petitioner's handwritten logs often have dates out of order and minimal notes. In his memorandum petitioner sought to substantiate some expenses by referencing personal logs and receipts that he did not provide”); Jenkins v. Commissioner, 1988 Tax Ct. Memo LEXIS 320, *37-38, T.C. Memo 1988-292, 55 T.C.M. (CCH) 1215, T.C.M. (RIA) 88292 (T.C. June 30, 1988) (finding no ledgers or tracking of receipts; no evidence for a business purpose; lack of billing; and salaries in excess of income).
9 Treas. Reg. § 1.183-2(b)(6).
10 Treas. Reg. § 1.183-2(b)(2).
11 Ford v. Comm'r, T.C. Memo 2018-8, 5, 2018 Tax Ct. Memo LEXIS 9, *4 (T.C. Jan. 25, 2018) Footnote 7; See Also: Treas. Reg. § 1.183-2(b)(4).
12 Ford v. Comm'r, T.C. Memo 2018-8, 3-4, 2018 Tax Ct. Memo LEXIS 9, *3.
13 Dana Trier, Deputy Assistant Secretary (Tax Policy), announced at the February 10 Real Estate and Partnership Tax Committee luncheon at the Winter Meeting of the ABA Tax Section that issues such as those connected with the new business interest limitation in section 163(j) and the new pass-through deduction in section 199A would be high priorities for early guidance.
14 I.R.C. § 199A(b)(2).
15 I.R.C. § 199A(e)(2).
16 I.R.C. § 199A(b)(2)(B). The threshold amount is $157,500 for singles and double that for joint returns, phasing out completely at $207,500 for singles and $415,000 for joint returns.
17 I.R.C. § 199A(d)(1).
18 I.R.C. § 199A(d)(2)(A)&(B).
19 I.R.C. § 199A(d)(2)(A).
20 I.R.C. §§ 199A(c)(1); 199A(c)(3)(B).
21 I.R.C. § 199A(c)(3)(B)(ii).
22 I.R.C. § 199A(c)(4).