Do you have a sole proprietorship or disregarded entity?
You might be an IRS target. The Treasury Inspector General for Tax Administration (TIGTA) has recently issued a report regarding opportunities for the IRS to audit more Schedule C businesses to have them classified as “hobbies”. In other words, the IRS says your business is a hobby.
As a former IRS tax compliance officer, this report is not at all surprising to me. Schedule C hobby loss issues are often messy and continue to be hot spot for IRS audits.
What the TIGTA report does not tell us is whether taxpayers are purposely sheltering income or if they are unaware of hobby loss rules. Section 183 is simply not comprehensible by most taxpayers. To compound the issue further, I do not believe that most tax compliance officers and revenue agents understand how to apply Section 183 hobby loss rules. First, there is a misconception that if the taxpayer does not have profits in 3 out of 5 years, the business is not for profit. The truth is that the 3 out of 5 year rule is a presumption of profit. But not meeting the three out of 5 year rule is not a presumption of a hobby. The examiner needs to further develop the issue by applying the 9 factor test to determine whether there is profit motive. To complicate things even more, none of the 9 factors are more important than the other, and there is no magic number of factors that need to be met. As a result, hobby loss rules are potentially applied inconsistently and arbitrarily. There is simply too much subjectivity involved in making this decision. The proper application of this rule would involve reviewing tax court cases to find similar fact patterns and determining how the court applied Section 183 to the facts. IRS auditors do not have the skill set to be able to make such highly interpretative and complex decisions. For attorneys to develop this skill set we receive 4 years of undergrad education and 3 years of legal education to understand how to read and interpret court cases.
I do not believe the answer to TIGTA’s findings is to audit more returns with schedule C hobby loss for the reasons mentioned above. The better solution is to revisit Section 183 hobby loss provision and make it 1.) Easier for taxpayers to understand; and 2.) Simpler for the IRS to apply. Changes to tax laws as they apply to sole proprietors and disregarded entities are long overdue.
Until the IRS provides better guidance for taxpayers and IRS auditors, we will continue to see hobby loss rules applied incorrectly and inconsistently. If the IRS decides your business lacks profit motive, they will also apply hobby loss rules to your prior year returns as long as there is still time on the statute of limitations. You may owe additional taxes for multiple years, including penalties and interest.
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