Deductibility of expenses under the business/hobby rules.

• Author: Hereth, Russell H.

Individuals engaged in certain endeavors cannot deduct their losses if the endeavor is "not engaged in for profit." The presumption of a profit motive can be achieved if the activity shows a profit in three years out of five (two years out of seven for horses). Even with three profitable years the IRS can still take the position that the activity is a hobby. However, the three profitable years create a presumption that the taxpayer has a profit motive unless the Service can prove otherwise.

If the taxpayer's activity does not show a profit in three years out of five, the taxpayer will have to rely on Regs. Sec. 1.183, which sets forth specific factors to be considered in the determination of profit intent. The following factors are to be considered in making the determination of the nature of an activity: * The manner in which the activity is carried on (e.g., if the activity is conducted in a businesslike manner). * The expertise of the taxpayer or his advisers. * The time and effort expended. * The expectation that the assets of the activity will appreciate in value. * The previous success of the taxpayer in the conduct of similar activities. * The history of income or losses from the activity. * The relationship of profits earned to losses incurred. * The financial status of the taxpayer (e.g., the fact that the taxpayer does not have substantial amounts of other income may indicate that the activity is engaged in for profit). * Elements of personal pleasure or recreation in the activity.

Literally interpreted, the general presumption of a profit motive applies only to the third profit year and all years thereafter within a five-year period beginning with the first profit year. Assume, for example, that a taxpayer is confronted with annual profits in 1989 through 1991 and losses in 1987, 1988, 1992 and 1993. The burden of proof rests on the IRS, therefore, for the years 1989 through 1993 to show that the taxpayer did not have a profit motive. The first two years of the operations, however, are not protected under the general presumption by the profit years of 1989 through 1991.

It is possible to combine a special presumption with the general presumption and to shift the burden of proof for the years 1987 and 1988 to the Service by filing Form 5213, Election To Postpone Determination as To Whether the Presumption That an Activity Is Engaged in for Profit Applies. This election can be made only once per venture and is effective for only...