Hobby Loss Audits: Proving a Profit Motive Under Section 183

A business that loses money is still a business. The tax law does not punish failure. What it does is ask whether you were engaged in the activity for profit. If not, section 183 limits the deductions, and losses from the activity stop sheltering your other income.

Examiners raise this issue when the pattern fits: consistent losses, an activity with personal or recreational appeal, and substantial income from somewhere else. Horse operations, farms on residential property, art, photography, crafts and collecting are familiar examples. But any activity can be challenged.

What section 183 does

IRC 183(a) says that if an activity of an individual or an S corporation is not engaged in for profit, no deduction attributable to the activity is allowed except as section 183 provides. Section 183(b) then allows two categories:

1. Deductions that are allowable regardless of whether the activity is for profit.
2. Other deductions that would be allowable if it were for profit, but only to the extent the activity's gross income exceeds the deductions in the first category.

The practical effect: in a not-for-profit activity, expenses can offset the activity's income but cannot create a loss that reduces your wages or other income. How the remaining deductions are treated on the return depends on other provisions that have changed over time, so check the rules for the specific year with a professional.

The presumption: three profitable years out of five

Section 183(d) gives you a presumption. If the activity's gross income exceeds its deductions in 3 or more of the 5 consecutive taxable years ending with the year in question, the activity is presumed to be engaged in for profit unless the IRS establishes the contrary. For activities that consist in major part of breeding, training, showing or racing horses, the test is 2 of 7 years.

Note that the presumption shifts the burden to the IRS but does not end the inquiry; the statute says "unless the Secretary establishes to the contrary."

The election to wait: Form 5213

New activities rarely show profits right away. Section 183(e) lets you elect to postpone the determination of whether the presumption applies until the close of the fourth taxable year (sixth, for horse activities) after the year you first engage in the activity. The IRS describes Form 5213 as the form individuals, trusts, estates and S corporations use to elect to postpone that determination.

There is a cost. Under 183(e)(4), if you make the election, the period for assessing any deficiency attributable to the activity does not expire before 2 years after the due date of the return for the last year in the 5-year (or 7-year) period. In other words, you keep every year of the window open longer. That trade-off deserves a careful look before you file the form.

The nine factors

When the presumption does not apply, the question is decided on all the facts and circumstances. Treas. Reg. 1.183-2(a) says the determination is made by reference to objective standards, that a reasonable expectation of profit is not required but the facts must show you entered or continued the activity with the objective of making a profit, and that "greater weight is given to objective facts than to the taxpayer's mere statement of his intent."

Treas. Reg. 1.183-2(b) lists factors that should normally be considered, while stating that no single factor is determinative and the case is not decided by counting factors:

Factor	What helps you
1. Manner in which the activity is carried on	Businesslike operation, complete and accurate books, changing methods to improve profitability
2. Knowledge of the taxpayer or advisors	Study of the field, consulting people who know it, and actually following their advice
3. Time and effort expended	Substantial personal time, especially on tasks without recreational appeal, or competent hired help
4. Expectation that assets will appreciate	Land or other assets expected to rise in value, so overall profit includes appreciation
5. Success in other activities	A track record of turning unprofitable ventures into profitable ones
6. History of income or losses	Losses explained by start-up phase or by events beyond your control, such as drought, disease, fire or depressed markets
7. Amount of occasional profits	Substantial occasional profits relative to losses and investment, or a real chance of a large profit
8. Financial status of the taxpayer	Lack of substantial other income or capital; heavy reliance on the activity
9. Elements of personal pleasure or recreation	Little appeal other than profit; or, if you enjoy it, other factors that show a profit objective

The regulation is fair to taxpayers on two points worth quoting in substance. Deriving personal pleasure from an activity is not enough to make it a hobby if other factors show a profit objective. And a small chance of a large profit can be enough; the regulation's own example is a wildcat oil driller.

What examiners look at

In practice, examiners test the factors with documents and questions:

• Books and records. Separate bank account, bookkeeping, financial statements. Commingled personal and activity spending looks like a hobby. See recordkeeping under IRC 6001.
• A business plan. Written projections, market research, a realistic path to profit, and evidence you revised the plan when it was not working.
• Changes in response to losses. Cutting unprofitable lines, raising prices, changing suppliers, hiring advice. The regulation specifically mentions abandoning unprofitable methods.
• Marketing. Advertising, a website, customer outreach. Selling only to friends is a weakness the regulation's own examples point to.
• Time logs. Who does the work and how many hours.
• The rest of your finances. Large other income is part of factor 8, and the interview will cover it. See the initial interview.

A note on S corporations

Section 183(a) applies to activities of individuals and S corporations. Putting a losing activity inside an S corporation does not take it outside the rule. The same factors apply to the activity, and the examiner will look at it the same way. Corporate formalities can help with factor 1, the businesslike manner of operation, but only if the business is actually run that way.

Also note the presumption counts years in which gross income exceeds deductions for the activity itself. One profitable year built on selling off the assets of a winding-down operation tells a different story than steady operating profits, and examiners read the numbers that way.

Building your defense

1. Check the presumption first. Count profitable years in the 5-year (or 7-year) window. If you meet it, say so and make the IRS carry its burden.
2. Go factor by factor and assemble documents for each, not just a narrative.
3. Explain the losses. Start-up periods and events outside your control are recognized in factor 6. Show what happened and when.
4. Show adaptation. A history of changes aimed at profitability is some of the strongest evidence there is.
5. Be candid about enjoyment. The regulation says it does not disqualify you. Pretending you hate your horses will not help your credibility.

If the examiner proposes to treat the activity as not for profit, the change appears on the Form 4549 report, often for multiple years. Scope expansion to other years with the same losses is common; see audit scope expansion.

Section 183 does not ask whether you succeeded. It asks whether you were trying, measured by what you did rather than what you say. Run the activity like a business, document it like a business, and you will be in a position to prove it.