The Hobby Loss Rule: Determining Factors Part II

From the Desk of Lauran L Stevenson
The Hobby Loss Rule: Determining Factors Part II

If a taxpayer does not meet the standards of the safe-harbor presumption, determining if an activity is engaged in for profit is a question of fact. Not one factor is determinative and the focal point of the analysis for determining if an activity is engaged in for profit is how the activity is treated by the taxpayer not the activity itself.

When determining whether an activity is engaged in for profit, the following factors are considered:

1. Manner in which the Taxpayer carried on the activity.
This factor focuses on how the taxpayer carries on the activity. If the taxpayer treats the activity like a business then it is more likely that a profit motive exists. Business-like behavior includes maintaining complete and accurate books and records. Conversely, lack of effort to maintain proper books and records supports a lack of profit motive.

2. Expertise of the taxpayer or his advisers.
This factor focuses on the preparation and study by the taxpayer regarding the activity. This factor includes a taxpayer relying on an expert’s advice on the economics of that activity and carries out that activity in accordance with this knowledge.

3. Time and effort expended by the taxpayer in carrying the activity.
When a taxpayer devotes substantial portion of his personal time and effort to carry out an activity (especially activities without recreational enjoyment), this tends to show that the taxpayer is engaged in the activity for profit.

4. Expectation that assets used in the activity will appreciate in value.
If the taxpayer does not expect ordinary income from the activity but expects that the property used in connection with the activity will appreciate in value. Expected appreciation alone is insufficient. The property must actual increase in value over the amount of operating expenses for the current year and from prior year losses.

5. Success of a taxpayer in carrying on with other similar or dissimilar activities.
If the taxpayer has engaged in prior similar actives that were profitable this is indicative that the current activity has a profit motive.

6. Taxpayers history of income or losses with respect to the activity.
Early losses may not be a proper indicator of a profit seeking motive. However, continued losses may be indicative of a lack of a profit motive unless attributable to facts and circumstances outside of the taxpayer’s control.

7. Amount of occasional profits, if any, which have been earned.
Occasional minimal profits obtained from an activity that has relatively high losses or requires a large investment indicates that activity is not engaged in for profit. On the other hand, when occasional profits are substantial or have an opportunity to be substantial, compared to losses and investment, that is indicative of a profit motive. The key is that where there is an opportunity to make a substantial profit, even if such profit is never realized, it is indicative of a profit seeking motive.

8. Financial Status of the Taxpayer.
This factor focuses on the taxpayer’s other sources of income. If the taxpayer has no other source of income and depends on the come from the activity, then it is likely to be considered activity for profit. Conversely, if the taxpayer has other sources of income and income from the activity is not meaningful, this fact tends to show the activity is not engaged in for profit. This factor essentially states that if your sole source of income is from the activity, it will be considered engaged in for profit. If not the only source of income, other factors should be relied on to show profit motive.

9. Personal Pleasure or Recreation.
This factor solely focuses on the enjoyment of the activity. Deriving pleasure from the activity does not necessarily negate a for profit motive. This is the most subjective factor by far and is reliant on other factors for support.