By: Brian Gordon, CPA
This article originally appeared in the July 2020 TaxStringer and is reprinted with permission from the New York State Society of Certified Public Accountants.
In a typical case, the IRS will audit federal tax issues, and when audit changes are made, it will notify New York State. With little additional work, New York will bill the taxpayer the amount of additional state tax resulting from these federal tax changes. Taxpayers are required to report the IRS audit changes on a New York State amended return within 90 days of the IRS notification, regardless of whether they receive a bill from the state.
While New York does enjoy the benefit of IRS audit results, it is allowed to audit any issue that affects its bottom-line taxable income. It is far from the state’s primary activity, but the New York State Department of Taxation and Finance has found it lucrative to audit some of these issues in addition to the audits being conducted by the IRS.
The Hobby Loss Issue
One of these issues is what is commonly known as the hobby loss issue. The IRS and New York State audit this issue because they’re concerned that taxpayers are trying to take losses from activities that are merely a hobby or otherwise have no opportunity to turn a profit.
The term “hobby loss” is used to describe an endeavor that often involves the arts, such as writing or painting, and results in mostly losses over an extended period of years. Also falling into this category are activities related to horse racing and car racing. People involved in such activities will often have other primary employment or sources of income. While it is true that sometimes these activities may just be expensive hobbies, very often they are legitimate businesses where the owner is working hard to be financially successful.
Many other activities that have frequent losses also fall into this audit category, such as farming and oil drilling. Although they’re not typical hobbies, the issue remains whether there is a real effort and possibility of turning a profit.
Sometimes actual hobbyists—not in business—can earn small amounts of income from their hobby. Although they are not operating a business, the income is still taxable. Prior to 2018, expenses for a hobby were allowed to the extent of the income generated from that hobby, but as a miscellaneous itemized deduction subject to the 2% adjusted gross income (AGI) limitation. Beginning with 2018 and the Tax Cuts and Jobs Act, hobby expenses are not allowed at all. Some consider this unfair; others argue that the standard deduction, which has been doubled under the act, makes up for this expense. Only an individual involved in a legitimate business can deduct expenses on a business return or Schedule C in excess of their income, resulting in a loss that can be used to reduce other types of taxable income.
Tax auditors will generally take the position that such activities are not a legitimate business; in their view, the activity is merely a hobby, where the entrepreneur may have occasional sales but little to no chance of turning a profit.
Under IRC section183(d), there is a presumption that if an activity shows a net profit in three out of five consecutive years, such activity shall be presumed to be engaged in for profit, unless the Secretary establishes to the contrary. (In the case of an activity that consists in major part of the breeding, training, showing, or racing of horses, the presumption is two out of seven years.) Very often, tax auditors will interpret this passage in the negative—that is, if a profit is not shown in three out of five years, then the activity is not engaged in for profit. But that is not what the passage states, and IRC section 183(d) is also merely a guideline for auditors, since the Secretary makes the final judgment. In such instances, the taxpayer will have the opportunity to present their case.
Factors to Consider
Treasury Regulations section1.183-2 lists nine factors that should be used to determine whether an activity is engaged in for profit. In a tax audit situation, a taxpayer or their representative should consider all the facts and circumstances in each activity and analyze it according to these nine factors. It would also be wise to analyze these factors before reporting a loss on a tax return. It’s important to note that these factors are not a points system where taxpayers can win or lose a case by a 5–4 margin. Some factors may weigh more heavily than others, depending on the facts of a case. They are also not necessarily all inclusive; other relevant facts may be included in the analysis.
The nine factors listed in Treasury Regulations section 1.183-2, modified by this author for brevity, are as follows:
Manner in which the taxpayer carries on the activity. The fact that the taxpayer carries on the activity in a businesslike manner and maintains complete and accurate books and records may indicate that the activity is engaged in for profit.
The expertise of the taxpayer or advisors. Preparation for the activity by extensive study of its accepted business, economic, and scientific practices, or consultation with experts, may indicate that the taxpayer has a profit motive in cases where the taxpayer carries on the activity in accordance with such practices.
The time and effort expended by the taxpayer in carrying on the activity. The fact that the taxpayer devotes much personal time and effort to carrying on an activity, particularly if the activity does not have substantial personal or recreational aspects, may indicate an intention to derive a profit.
Expectation that assets used in activity may appreciate in value. The term “profit” encompasses appreciation in the value of assets, such as land, used in the activity. Thus, the taxpayer may intend to derive a profit from the operation of the activity, and may also intend that, even if no profit is derived from current operations, an overall profit will result when appreciation in the value of land used in the activity is realized.
The success of the taxpayer in carrying on other similar or dissimilar activities. The fact that the taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable enterprises may indicate that the taxpaer is engaged in the present activity for profit.
The taxpayer's history of income or losses with respect to the activity. Losses that continue to be sustained beyond the period customarily necessary to bring the operation to profitable status, if not explainable as due to customary business risks or reverses, may indicate that the activity is not being engaged in for profit.
The amount of occasional profits, if any, that are earned. The amount of profits in relation to the amount of losses incurred, and in relation to the amount of the taxpayer's investment and the value of the assets used in the activity, may provide useful criteria.An opportunity to earn a substantial ultimate profit in a highly speculative venture is ordinarily sufficient to indicate that the activity is engaged in for profit.
The financial status of the taxpayer. The fact that the taxpayer does not have substantial income or capital from sources other than the activity may indicate that an activity is engaged in for profit.
Elements of personal pleasure or recreation. The presence of personal motives in carrying on of an activity may indicate that the activity is not engaged in for profit, especially where there are recreational or personal elements involved; however, the fact that the taxpayer derives personal pleasure is not sufficient to cause the activity to be classified as a hobby if the activity is in fact engaged in for profit as evidenced by other factors.
Brian Gordon, CPA, is president of State Tax Audit Representation, Inc., a tax audit and controversy representation firm. He represents clients on audits involving residency, sales tax, corporation tax, and various other state and local tax and collection matters as well as IRS matters. Previously, Mr. Gordon was with the New York State Department of Taxation and Finance for many years as the district audit manager in the New York Metropolitan District, where he worked on many high net worth tax audits of all types. Following his government experience, he was state and local tax director, most recently at Gettry Marcus, CPA, PC. He is a former president of the NYSSCPA Queens/Brooklyn Chapter and a member of the NYSSCPA New York, Multistate & Local Taxation Committee. He writes and speaks on various state and local tax issues. He can be reached at 516-510-6041 or bgordon@StateTaxAuditRep.com, and would be happy to clarify this topic or answer any questions on how to analyze your situation.