Reform “hobby” rules for equity and possible improved compliance

Following up on my 6/25/23 post about an idea I included in testimony submitted for the written record of a small business tax complexity hearing held on June 7, here is another idea I proposed:

Reform “hobby” rules for equity and possible improved compliance

IRC Section 183, Activities not engaged in for profit, imposes limitations on deductions for activities that generate revenues but not IRC Section 162 deductions. Under this provision, deductions are allowed up to the amount of gross income from the “hobby”, with gross income measured as receipts less cost of sales. The allowed deductions though are only deductible if the taxpayer itemizes deductions and are treated as miscellaneous itemized deductions subject to the 2-percent-of-AGI threshold of IRC Section 67. For 2018 through 2025, such deductions are not allowed at all.

IRC Section 183 should be reformed to treat the allowable deductions as deductible for AGI, but still limited to gross income without any carryforward if deductions exceed gross income. The Joint Committee on Taxation defines the “normal structure” of the individual income tax as including deductions for investment and employee business expenses. [JCT, Estimates Of Federal Tax Expenditures For Fiscal Years 2022-2026, JCX-22-22 (Dec. 22, 2022), page 4]  The logic for this is that these expenses are incurred to generate taxable income and a “normal” income tax would allow such deductions. This argument also justifies allowing a deduction for the reasonable expenses of producing hobby revenues.

Another benefit of reforming IRC Section 183 is that it may reduce the inclination some taxpayers might have to treat a hobby as a business in order to claim the deductions for AGI.

What do you think?

Revenues and customers can still be a hobby

For a few years, I have noted in update presentations and elsewhere that some gig drivers who only drive occasionally, do it for cash generation or to pass the time, or have other income sources, might really have an activity not engaged in for profit ("hobby"), rather than a business. The tax consequences of the hobby designation are tremendous in that no deductions are allowed starting in 2018. No self-employment tax is owed either, but loss of tax deductions for a gig driver is costly.  Following is an example of a taxpayer with revenues, customers and a business premises who was found not to be engaged in a business.

Revenues Not Enough to Indicate Business – Ford, TC Memo 2018-8 (1/25/18), aff’d No. 18-1524 (6^th Cir., 11/5/18, not for publication) – F used to be recording artist and spend most of her life promoting and performing country music. For the years under exam -  2012 through 2014, she owned and operated the Bell Cove Club in Tennessee on her own. Earlier, she and her husband operated this club (starting in 1986) and wanted it to be a place where artists could perform for talent scouts and producers. It closed when her husband died in 1999 but Joy reopened it in 2008. Customers only had to pay $5 for admission and a small amount for food. F paid performers. Losses were generated. F had some plans she pursued to convert the club into a restaurant or televise the performances, but these changes did not materialize. The IRS disallowed the losses finding the club not operated for profit. The court agreed finding the club was operated mostly for personal pleasure rather than profit with the losses offsetting investment income of F.

F appealed to the 6^th Circuit which upheld the Tax Court decision as it did not find any error in that court’s analysis. At the start, the 6^th Circuit notes:

“’Find a job doing something you love.’ Perhaps that is sound advice.  But deducting business losses from your taxes when you are not trying to profit from the business you love is not a sound strategy.  Here, the Tax Court found that the appellant did just that: ran a business doing something she loved, accumulated substantial losses, and deducted those losses from her income. Because the court below did not commit clear error in making this determination, we AFFIRM.” The court re-examined the factors under Reg. 1.183-2 that help distinguish a business from an activity not engaged in for profit and concluded that the club wasn’t operated in a for-profit manner. For example, the court noted that Ford did nothing to reduce costs, leaving empty refrigerators and stage lights running even when the club wasn’t open for business. Also, she did not adjust the cover charge to help make a profit. In addition, she did not want to serve alcohol, but let patrons bring in their own. Per the court: “The record paints a picture of a business operated without regard to cost or profit. There is nothing indicating Ford operated in a “business-like manner.””

Observations: The Tax Court generally applied Reg. 1.183-2 without going through a detailed analysis of each of the nine factors. In contrast, the 6^th Circuit analyzed each of the nine factors. But both courts concluded that the club was an activity not engaged in for profit (a hobby). Often, we think that an activity with customers and revenues is automatically a business. But more is needed under IRC sections 162 and 183 and the regulations and court cases. Today, this issue can arise with some occasional, part-time gig workers. They generate income from, for example, using the Uber or Lyft platform, but do not set prices, have no business plan, do not regularly engage in the activity, do not have separate financial records, may be doing the activity to generate cash for bills and/or pass the time. These individuals may fall into the same situation as Joy Ford. A tax adviser can help these individuals to convert their hobby or activity at risk of being a hobby into a business by following the Reg. 1.183-2 factors to make the activity a business. After the TCJA, a hobby means all of the revenue is reported, but no deductions are allowed.

What do you think?