Aggregating activities to avoid the hobby loss rules.

• Author: Harmon, Michael R.

EXECUTIVE SUMMARY

* Sec. 183 limits the deduction for activities not engaged in for profit. In determining whether an activity is engaged in for profit, the regulations allow taxpayers in some circumstances to aggregate separate activities for tax purposes.

* The regulations provide the general factors considered when deciding whether a taxpayer can aggregate activities. The three primary factors are the degree of organization and economic interrelationship of the activities, the business purpose for treating the activities as separate activities or as one activity, and the similarity of the activities.

* The courts have generally required a close similarity between the activities; however, in the Topping case, the Tax Court relaxed this requirement considerably and allowed a taxpayer to combine her equestrian activities with her home and barn design activity.

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Sec. 183 limits deductions for activities that are "not engaged in for profit,'" commonly called hobbies. To sidestep this requirement, taxpayers often attempt to combine activities that would separately be considered hobbies with other activities to avoid the Sec. 183 limits. In fact, the regulations under Sec. 183 (1) specifically allow the aggregation of undertakings into one activity. By doing this, a taxpayer may combine an activity that is unprofitable and does not meet the presumption of being "engaged in for profit" into another for-profit activity so the deduction limitations of Sec. 183 do not apply.

Historically, the courts have sanctioned this treatment but required that the two activities be somewhat similar in kind. For example, a farmer was allowed to aggregate his rodeo and horse breeding activities, (2) and another taxpayer was allowed to aggregate his farming, hunting, riding lesson, crabbing, horse breeding, horse boarding, and horse racing activities. (3) However, the Tax Court recently relaxed the similarity requirement in Topping, (4) where the court aggregated the taxpayer's barn and interior design business with her equestrian activities. A review of the cases suggests that these undertakings are arguably the two most disparate activities that the courts have allowed a taxpayer to combine. Nevertheless, the court's reasons for doing so seem rational and justified. This article explores those reasons and examines other cases in which taxpayers have not been so lucky.

Overview of Sec. 183

Sec. 183 generally provides that taxpayers cannot deduct expenses attributable to any activity not engaged in for profit. However, this wholesale disallowance of deductions is relaxed in Sec. 183(b), which permits deductions related to such activities to the extent of gross income from those activities. The provision applies to individuals and S corporations but not to C corporations.

Activity Not Engaged In for Profit

The critical test of Sec. 183 is determining whether an activity is profit oriented or merely a hobby. Unfortunately, the Code is not very helpful in making this distinction. Sec. 183 simply states that "the term 'activity not engaged in for profit' means any activity other than one with respect to which deductions are allowable ... under section 162 or under ... section 212." (5) Regs. Sec. 1.183-2(a) does provide some guidance, indicating that all facts and circumstances should be taken into account in making the determination and then listing nine factors--all derived from pre-1969 case law--that should ordinarily be considered: (6)

* How the taxpayer carries on the activity;

* The expertise of the taxpayer or his or her advisers;

* The time and effort the taxpayer expends in carrying on the activity;

* An expectation that assets used in the activity may appreciate in value;

* The taxpayer's success in carrying on other similar or dissimilar activities;

* The taxpayer's history of income or losses with respect to the activity;

* The amount of occasional profits earned, if any;

* The taxpayer's financial status; and

* Elements of personal pleasure or recreation.

The regulations do not weight the factors in any manner, explaining that no one factor is determinative. Moreover, they make it clear that this is not an exhaustive list and that other factors may exist. It is also worth noting that because the IRS distilled these factors from prior case law, the courts believe such prior law "has a role to play in their application." (7)

Expectation of profit: It should be emphasized that the regulations indicate that a "reasonable expectation of profit is not required." However, the facts and circumstances must demonstrate that there was an objective of making a profit. Case law echoes this sentiment, stating that the taxpayer need not show a realistic expectation of profit but only an actual, honest one. (8)

Presumption: To reduce litigation over the above factors, Sec. 183(d) states that if any activity has been profitable in three or more of five consecutive years (two of seven years for most horse activities), the activity is presumed to be engaged in for profit. The presumption does not provide immunity. Rather, it is rebuttable, merely shifting the burden of proof from the taxpayer to the IRS.

Election: The taxpayer may elect that the above presumption not be made until the fourth year (sixth year for horse activities) after the start of the activity. This gives the taxpayer more time to meet the presumption. The downside is that by making the election, the taxpayer extends the statute of limitation for assessment for two years after the end of the fifth year (seventh for horses) of the activity. Thus, the IRS can go back over the entire activity time covered by the election and assess a deficiency. (9) Moreover, some practitioners believe that by filing the form, the taxpayer is sending a clear signal to the government that a problem may exist.

Treatment

If the activity is determined not to be engaged in for profit, there are several ramifications:

* Deductions for the activity are limited to gross income from the activity.

* All deductions are itemized deductions. (10) However, otherwise allowable deductions such as interest expense and property taxes are deductible in full as itemized deductions, While other deductions related to the activity are considered miscellaneous itemized deductions subject to the 2% floor and the deduction cutback rule.

* Income is included in gross income, thereby increasing adjusted gross income and potentially increasing the deductible threshold for miscellaneous itemized deductions.

Further discussion of the above topics is beyond the scope of this article.

Aggregation

Hiding a hobby--a loss activity--within a legitimate business that is profitable is not a new phenomenon, notwithstanding recent judicial activity in the area. This has long been a strategy for taxpayers and a concern for the government, so it is not surprising that the regulations acknowledge the possibility. Regarding the combination of one or more activities, Regs. Sec. 1.183-1(d)(1) does not specifically define the scope of an activity, nor does it use the word "aggregation." (11) However, the regulations explain that "where the taxpayer is engaged in several undertakings, each of these may be a separate activity, or several undertakings may constitute one activity." The regulations state that this determination must be made using all the facts and circumstances and then list the following as generally being the most significant:

* The degree of organization and economic interrelationship of various undertakings;

* The business purpose that is (or might be) served by carrying on the various undertakings separately or together in a trade or business; and

* The similarity of various undertakings. (12)

The regulation goes on to say that generally "the Commissioner will accept the characterization by the taxpayer.... The taxpayer's characterization will not be accepted, however, when it appears to be artificial and cannot be reasonably supported." (13) There are no relevant examples in the regulations, but several cases have interpreted this language.

Aggregation Not Allowed

In Schlafer, (14) the taxpayer owned an auto dealership and ran a stock car racing activity. On his 1984 and 1985 returns, he attempted to offset his racing losses of about $23,000 each year against the profits of his car dealership. At trial, Schlafer contended in part that the expenses incurred in the racing activity were merely advertising for his car dealership. He explained that the cars prominently carried the logo of his dealership, and ads for the dealership he placed in racing programs showed the race car with the logo. In denying the deduction, the Tax Court held that the two undertakings were separate activities. In so holding, the court first cited the regulations above and then found that the taxpayer kept the activities separate and distinct.

The assets used in the racing activity were not on the books of the dealership; when the dealership paid for racing repairs or assets, the amounts were shown as receivables from the taxpayer personally; and the income and expenses were treated separately on the tax return. Based on these...