Minimizing a hobby loss issue by electing S status.

• Author: Baer, John

If an activity is not engaged in for profit, the "hobby loss" rules of Sec. 183(a) provide that deductions in excess of gross income are not allowable. This statute specifically applies to activities engaged in by both individuals and S corporations. Accordingly, the mere form of conducting business is not the determinative factor in the hobby loss issue.

Due to the suspension of miscellaneous itemized deductions in the years 2018 through 2025, deductions for hobby expenses under Sec. 183 are not allowed in those years (Sec. 67(g), as added by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97). The inability of a taxpayer to deduct even a portion of the hobby expenses while recognizing all the hobby income in adjusted gross income makes establishing a profit motive for a hobby activity even more desirable.

The question of whether an activity is engaged in for profit involves a series of subjective interpretations regarding the business. The regulations list nine relevant factors to consider when determining whether an activity is engaged in for profit (Regs. Sec. 1.183-2(b)):

* The manner in which the taxpayer carries on the activity, including such formalities as maintaining books and records;

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

* The time and effort expended by the taxpayer 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 activities;

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

* The amount of occasional profits that are earned;

* The financial status of the taxpayer; and

* The elements of personal pleasure or recreation involved with the activity.

Planning tip: Although an activity must be engaged in for profit to avoid the hobby loss rules, a predictable or highly probable expectation of profit is not required. For example, a taxpayer may well have a profit motive for investing in a very risky venture (e.g., wildcat oil and gas drilling or providing capital to startup businesses). The circumstances should indicate that the taxpayer entered into or continued the activity with the honest objective of making a profit, but even risky investments can be considered made for a profit motive.

The following example illustrates planning devices that can be used to reduce the chances that a hobby loss issue will arise.

Example. Planning to avoid the hobby loss issue: G owns a...