Is Your Work A Hobby Or A Business?

Tax Court litigation arose in Los Angeles County, California which surprised my client who currently conducts his business in West Los Angeles. The IRS issued a Notice of Deficiency (the so-called “90 day letter”) disallowing business expenses my client knew were legitimate. The earlier IRS audit claimed my client was engaged in a hobby and hobby losses are not deductible. Through his accountant, my client retained me as his tax attorney to fight the IRS to contest the proposed income tax, penalty and interest assessment.

My client sold his former business in Orange County years before he began a new phase of his career when we met. My client’s new business was to seek out ideas in the technology field for the purpose of identifying exploitable opportunities around which he could assemble a team of experts to build another going-concern to deploy to the public and later sell at a profit.

To uncover profitable business opportunities and as one of several methods methodically employed, my client did what other early-stage investors did by forming a private equity firm specializing in advising, investing in and acquiring middle market companies. The private equity firm was a sole proprietorship and not an entity in California such as an LLC, partnership, subchapter C or S corporation.

He looked for opportunity in corporate divestitures, succession planning of family-owned businesses, entrepreneurial exits and restructurings of public and private entities. He sought to make investments or acquisitions providing them with control so as to be able to drive a business in the manner he thought would have been in the interest of making a profit. He focused on continually building value in his companies by partnering with strong management teams, adding experienced leadership and developing growth strategies.

My client, the taxpayer, did this for five years before we met but he never made a profit during any of those years. Consequently, the IRS asserted his activities were a hobby and the expenses he incurred were disallowed for all five years.

People prefer to make a living doing something they like. A hobby is an activity for which you do not expect to make a profit. The IRS claims that if you do not carry on your business or investment activity to make a profit, you cannot use a loss from the activity to offset other income. Activities you do as a hobby, or mainly for sport or recreation, are often not entered into for profit.

In determining if my client’s activity was engaged in for profit, nine factors must be reviewed although not every factor is relevant.

The time and effort you put into the activity indicate you intend to make it profitable

You were successful in making a profit in similar activities in the past
Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business)

You change your methods of operation in an attempt to improve profitability

You depend on income from the activity for your livelihood

The activity makes a profit in some years, and the amount of profit it makes

You can expect to make a future profit from the appreciation of the assets used in the activity
You carry on the activity in a business-like manner
You, or your advisors, have the knowledge needed to carry on the activity as a successful business

The limit on not-for-profit losses applies to individuals, partnerships, estates trusts, and S corporations. It does not apply to corporations other than S corporations. My client operated as a sole proprietorship.

For details about not-for-profit activities, refer to Publication 535, Business Expenses.

The Tax Court Petition we prepared demonstrated that my client satisfied all nine tests and we provided plenty of examples.

We won. The IRS conceded all of the issues for each of the years involved and did not go forward with its proposed income tax assessment.

To speak with a qualified tax attorney about a tax controversy, call Mitchell A. Port at (310) 559-5259.