Under Internal Revenue Code Section 183, business tax deductions are disallowed for any activity that is “not engaged in for profit.” Better known as the “hobby loss provision,” Section 183 states that an activity is for profit if it is profitable for at least three consecutive years of a consecutive five-year period; an exception is two of seven years for breeding, training, showing or racing horses.
TIGTA’s current audit, issued April 12, 2016, was conducted to determine whether the IRS was maximizing its capabilities in identifying the most significant Schedule C noncompliance activities, and consequently, minimizing improper claiming of losses. TIGTA found that the IRS can improve its methods to determine whether taxpayers are in compliance with these hobby loss provisions. In fact, TIGTA estimated that 7,511 returns out of a sample of 9,699 individual returns (containing certain attributes) may have improperly used hobby loss expenses to reduce taxes by as much as $70.9 million for tax year 2013 (about $9,400 per return).
TIGTA has recommended that the IRS do the following:
- Make use of Small Business/Self-Employed Division research capabilities to identify high-income individual returns with multi-year Schedule C losses and other factors that indicate the taxpayer may not have a profit or capital gain motive for the activity.
- Emphasize the importance of required filing in the preliminary determination of whether to pursue a hobby loss issue, and provide tools to assist examiners in documenting their conclusion.
The IRS has agreed to take certain corrective actions, although there is no guarantee this will stick. Key indicators of a problem Schedule C include the number of loss years, zero or minimal gross receipts, and other sources of income sufficient to cover the living expenses of the taxpayer.