In episode 49 of How Tax Works, Matt Foreman discusses hobby losses, which are a significant and often underappreciated limitation on the ability to deduct losses based on the taxpayer’s profit motive.

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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

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Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matthew Foreman [00:00:00]:
Welcome to the 49th episode of How Tax Works. I’m Matt Foreman. In this episode I’m going to talk about what is a hobby and what is a business, which only matters if you lose money or in short, hobby loss limitation rules. How Tax Works is meant for informational and entertainment purposes only. Business this may be attorney advertising and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business decisions we make before we get started.

Matthew Foreman [00:00:45]:
Administrative stuff and new episodes in every two weeks. That next episode is going to talk about probably deducting losses from scams, theft and similar situations. I’m not 100% sure. There may be another one dependent if I kind of get around to doing it and outlining it and it relates to sales and use taxes and registering cars in Montana. If you find it funny when things, bad things happen to people who are, who are defrauding the government of tax revenue, you’ll enjoy this one because it’s a, it’s a chuckle. If you have any questions, comments or constructive assuming get to that. That’ll be one of the next couple. If you have any questions, comments or constructive criticism, you can email me at my FRB email address, which you can find via your favorite search engine.

Matthew Foreman [00:01:26]:
Upcoming Webinars Like I said, follow me on link. You know, connect me on LinkedIn. Just say you found it this way and you’ll see when I post anything about when I’m talking podcasts, articles, things like that. Actually had a pretty recent one about the the post office rules and how they’re stamping and how it matters for the mailbox rule, which for those of us who either file returns or communicate with the IRS or people file elections or anything like that is a really, actually can be a really important rule. Anyway, I’ve been yammering for a minute and a half, two minutes and it’s time to talk about the hobby loss rules, right? So to take deductions in excess of losses, you must be engaged in the activity for profit, right? So other there’s, and that’s, that’s, that’s 183, right? That’s the idea of hobby loss rules. But there’s there’s four others, right? There’s, there’s, you have to have basis. There’s 469 passive activity loss rules, which I’ve talked about a bunch of times in this podcast before. 465 at risk rules.

Matthew Foreman [00:02:23]:
461 L, which is a limitation on going from loss from one business Offsetting Another was $250,000. It’s now well over $300,000 because of inflation. So. So that’s that. I’m going to talk in this one before I get into anything about Grotzinger. A lot and not that much, actually, but it’s in the context of it because in Grotzinger there was really like, is this a business? Is this a business? Or is this the hobby think about? Grotzinger was, you know, we talk about a lot for the passive. Active, passive rules. Because a lot of the ideas behind lobby loss rules are really similar to the passive rules.

Matthew Foreman [00:03:00]:
You’re not doing that much. You don’t really care. It’s not really a business. They often. 469 and 183. One of the two gets you. Sometimes it’s an obvious business. You’re just not doing it a lot.

Matthew Foreman [00:03:12]:
Sometimes you’re doing it a lot, but it’s not an obvious business. You’re not trying to make money. And that was part of the issue with Grotzinger. Right. 480 U.S. 23. He was a gambler in dog races. He was trying to make money and he was not good at it.

Matthew Foreman [00:03:25]:
Let’s be candid here. He was not good. So I think it’s really important. There is a nine factor test under Treasury Regulation 1.1832 B to determine the profit motive. I am. I’m going to redo the. The. The nine factors.

Matthew Foreman [00:03:40]:
Get some music and I’m going to come back and the whole episode is walking through those factors. They are a bit of a bear and they can be tough. And it’s an uphill battle. And I think that’s important. All right. Factor one, the manner in which the activity is conducted. Factor two, expertise of the taxpayer or their advisors. Factor three, time and effort expended by the taxpayer.

Matthew Foreman [00:04:02]:
Factor four, the expectation that the assets may appreciate. Factor five, success in similar activities. Six, history of income or losses either in that business or other one. Factor seven, amount of occasional, amount of occasional profits, frequency of profits, things like that. Eight, my least favorite one, financial status of taxpayer. I think it’s crap. Factor nine, elements of personal pleasure or recreation. So that.

Matthew Foreman [00:04:30]:
That’s it. That’s. That’s the nine. We’re gonna get some music in. We’re taking an early music break on this one, but I think it’s important because this one’s gonna get Kind of deep. I’ll be back in a minute. Right before I get into the nine factors and welcome back. There are five thousands that might be an exaggeration.

Matthew Foreman [00:05:07]:
There are thousands of cases, right. That go through a lot of these factors and have this issue. And someone once said in the context of 469 and it’s true on this one, on 183 too. Is that you? How do I, how do I say this politely? A lot of the taxpayers lose because they have bad facts. The IRS is not out there or states whatever is not out there litigating good facts. They’re litigating mediocre and bad facts. Good facts pass audit or they settle. So you’re gonna get a lot of really bad fact patterns.

Matthew Foreman [00:05:37]:
So if there is an audit on this and this is what you’re fighting it’s about a lot of the audit defense is showing why you’re different than the yucca pucks otherwise. So a. So before I get into them, really, first off, the tests are unavoidably subjective. The goal of section 183 is to create an objective. Objective factors, but it’s based on facts and circumstances. Right? So that’s necessarily unavoidably subjective. They talk about that in the Senate report. Senate report number five to 52, 91st Congress first session 19 first session 104, 1969.

Matthew Foreman [00:06:07]:
So. So 183 is not new. It was actually kind of the in a lot of ways the first time to try to stop the 465, 469 issue. Obviously modifications, stuff like that, you know, different facts. But it’s really important to note that it is necessarily done how to. How to wait between the factors. Right. You have to look at objective facts more than subjective.

Matthew Foreman [00:06:27]:
Falconer 748 Fed. 2nd 894th Thomas 792 Fed. 2nd 1256. Those are both 4th Circuit case and treasury regulation 1.1832 a talks about that. This is really important and there’s a couple cases that talk about this that there are no examples in regulations that cover the idea of a wealthy taxpayer with large losses from an enjoyable activity conducted in business like manner. Okay, so it is the good facts and I’ll talk about that in a second. But is someone who has a lot of good facts but just has a lot of money otherwise. And the IRS sort of generally looks them as bad.

Matthew Foreman [00:07:03]:
So there’s Watley TC Memo 202111 which was a timber farm and WP Realty LP TC Memo 2019, 120 as a golf course and a world class great golf course too. And what they were seemingly sort of having problem with is like, okay, well this can be a, a business and you run it like a business, but you’re so wealthy that we just don’t think it’s actually a business. We think you’re just writing off expenses and that’s something you have to fight against. So that brings us really nicely into. And this is the intro to talk about the first factor. Number one, the manner in which the taxpayer carries on the activity. Business like or professional, okay? You must maintain adequate records. Not perfect, merely adequate, regular records.

Matthew Foreman [00:07:49]:
Keep records regularly, don’t just kind of like occasionally do it. The record keeping has to be consistent with industry or otherwise. You know, there are a lot of businesses that don’t keep great records. So be consistent with your industry. Less worried about being consistent with every business. A lot, let’s be honest, a lot of horse breeding, for example, isn’t really done as a business, right? So carry on. If you’re worried about it, carry on. Better records.

Matthew Foreman [00:08:14]:
Make that strong. The other point in this is in carrying on the trader business the way you do it is if the business is not making money, you show that you’re trying, which I’m always sort of fascinated that that’s like something I have to explain. But if you’re not making money, are you changing your operations, right? Is this just a dry patch? Is this a startup? I’ll talk about that later. And there’s other factors to deal with it. Or you, you’re changing this, you’re changing your marketing, you’re changing how you’re doing things, you’re firing people, you’re moving around who, who does what business, et cetera, et cetera. You know that that’s a really important one. If you keep losing money and you keep doing the same thing, A, that’s the definition of insanity, right? Doing something different or doing the same thing, expecting a different result. And B, it suggests that you really don’t care about making money, right? So because if you’re a business and you’re really trying to make money, you’re not going to keep doing that.

Matthew Foreman [00:09:15]:
You’re just not. And that’s really important in that, in that situation. IRS is very correct. Number two, expertise of taxpayer, their advisors, accepted business, economic and scientific practices. You can hire a consultant, you don’t know what you’re doing, but you hire someone to do it. Hire, hire a consultant, hire an expert, you consult with an expert, whatever it is that Kind of stuff that really helps. That’s really, really big if you’re doing it. And it’s not even necessarily advisors and experts in the area which you’re doing.

Matthew Foreman [00:09:43]:
If you’re meeting with, if you have an accountant, you’re like, well, look, what’s going wrong? Where am I losing money? How can I do this? What’s doing? Well, you know, you’re looking at your, your business analytics look like, maybe if we advertise here and move this around or we do this, we change our pricing, that can do it. And that’s important, right? Not just expertise in, in the specific operating the business, but operating it as a business. Right? And I think that’s really important. Goes back to the manner in which the taxpayer carries on the activity. Factor one, but it’s important. Seminars, trade shows, studying at home, buying books, right? Appraisals. Appraisals and using data, right? Those are really big. Is this a good purchase? Does this make sense? Number three, time and effort expended by the taxpayer and carrying on the activity, especially if there’s no other activity or business.

Matthew Foreman [00:10:26]:
It’s good. It’s good if you, you know, look, if you lose income elsewhere, right? That, that’s important. You know, you just don’t want someone who, what the IRS never believes right or wrong is someone who makes a lot of money or has a huge amount of assets, isn’t spending a lot of money on it. But, oh, it’s a business. It’s a business. It’s trouble. Troublesome, right? Limited time is okay if you hire competent and qualified persons. So you may not be spending 30,000 hours on it.

Matthew Foreman [00:10:53]:
Still, the passive rules that come into play, but if you hire people who are good at it, you’re just losing money, you know, that’s it. Limited time is okay based on facts. There’s a great case. Cart Cartrude TC Memo 1988 498. The guy was a stunt flyer, right? So he was flying airplanes to do stunts upside down. You know, loop de loop, stuff like that. And it’s just really dangerous. There’s limited opportunities to do it.

Matthew Foreman [00:11:21]:
And like, let’s be honest, if you’re spending a hundred thousand hours doing it, like, that’s not great. You know, you’re gonna get too used to it. You’re gonna take big risks. Could get, you know, you’re doing it when it’s too windy out, et cetera. So they’re like, look, you didn’t spend a lot of time on it. You only spent like, I think, like 90 hours in the year, if my recollection is correct. But like it’s the nature of the business, right? There’s really specific carve outs. So you know, good job by that, by that advisor who came up with that argument.

Matthew Foreman [00:11:48]:
It’s a, it’s a good argument. Number four, which is a really interesting one, which is the expectation that assets used in this activity may appreciate in value. Okay, Collectibles, horse breeding, real estate. Real estate’s a really big one. The other ones also come into it. We’ll talk about it, you know, a little bit. But you know, you buy land for a farm and appreciation, that’s a really strong 1. Treasure Egg 1.1831 D 1.

Matthew Foreman [00:12:15]:
Roberts TC Memo 201474 Golanti 72 TC 411 Burris TC Memo 22,003, 285. You wait. One of the important things, you weigh the income now and the appreciation. A lot of cases, a lot of very, very fact, specific cases. What they’re, what they don’t want is someone who’s going to lose money, have all sorts of ordinary losses for, for 10 years. At the end of 10 years, they’re gonna have a huge capital gain, right? They don’t want that. And because what they’re saying is, well, you just bought this to convert, you know, ordinary income, defer it and have capital gains. That’s important and that’s a big one.

Matthew Foreman [00:12:49]:
Collectibles are important. Horse breeding and horse training and riding horses, they are like super, super dubious of that because, because horse activities are really expensive. They’re like, oh, but if we do this and we’ll lose $200,000 on this horse and then we’ll sell it for a million dollars, right? We’ll make a million dollars on it maybe, you know, how long does it take? How big are the losses? Things like that keep records, keep records, keep records. A lot of people where they fail is they don’t keep great records of what they’re trying to do and how they’re operating the business. And there aren’t great accounting records. You know, they know how much money they made or loss, but they don’t totally know it was on what, you know, like I spent it on my credit card. No, no, keep it. You know, that’s important.

Matthew Foreman [00:13:31]:
Number five, the tax rate of success in carrying on other similar or even dissimilar businesses. Previous profit in a similar activity is extremely big. Brooks 274 Fed, second 96, the 9th Circuit case. There’s a lot of those cases. There are A lot, a lot, A lot of those cases that say you’ve done this before, you’ve been successful, you’re doing it again, that’s it. Successful elsewhere but new to this business is not that bad. There’s a lot of cases. There’s actually a real, a lot of fact pattern.

Matthew Foreman [00:13:59]:
One I’ve seen before that was audited and then I don’t say drop but the auditor just like we’re not going to get anywhere on this and moved on was someone who would just kind of buy businesses and he had a team that would turn them around and they were sort of related but he was just really good at turning around businesses. He had a good team for it. So he was good at carrying on dissimilar businesses but the same idea and he’d lose money for some of them for a while. Some of them he never really made money. They said oh you really trying to make money? And the answer is yes. And we felt pretty good about that. There’s a lot of cases on it. Miles TC Memo 1983206 Hogan TC Summary Opinion 20038 really, really interesting 1 is is Doherty 45 TCM 11224 is, is the guy grew up on a family farm as a child.

Matthew Foreman [00:14:48]:
He worked on the farm as a child but you know, children don’t run the farm, right? Obviously I hope not, right. Children of corn kind of situation. And, and he was successful in other businesses. Basically grew up, became a very big success, made a lot of money and he, he, he bought a farm and he lost money on the farm for a while. Right. And they said look like I’m just not turning it around yet, but I will and I believe it, I believe this will be a profitable business in the end. That’s actually, you know, that was, that was already, that was a good fact pattern. He did well with that.

Matthew Foreman [00:15:20]:
They allowed the losses. So I think that’s a really important one. I think that’s one you need to think about is success. Prior success or prior experience is, can be really important. But if you’re just kind of generally bad at, bad at business and it’s a new business, that may not be a great fact pattern. I’m going to touch on it a bit later when I talk about you know, one of the later ones which is the taxpayers financial status but just someone who keeps losing money and kind of, of keep losing money. IRS is just dubious of it. All right, we’re going to, going to get a little, little, little music break in and then we’re Gonna, we’re gonna go.

Matthew Foreman [00:16:15]:
All right. All right, we’re back. So number six, six factor is the taxpayer’s history of income or losses in this activity. I kind of talked about it a bunch in number five. But you know, a prior income in some business, in the same business previously, great fact. Sustained and repeat losses. You keep losing money in the same business, eventually they’re going to be like, well, I don’t know about this, right. There’s a real, there’s a real humdinger of a case.

Matthew Foreman [00:16:42]:
Skolnick TC Memo 20, 21, 139. It was also affirmed in the third circuit. Skolnik and the dude had 16 years of losses. 16. And I gotta tell you, the IRS and the tax court were both extremely suspect of the idea that this was a business. There was one Giles TC memo 2005s 28 losses for basically 30 years. Had one year of profit. That was a little over 200 bucks.

Matthew Foreman [00:17:12]:
Horse activity yet? No, no, no, no. You have to like at some point make money in that one. You know, there’s, there’s startup losses. A lot of businesses that are startups lose money for a significant period of time. 3, 5, 7, 10 years. Some of them, you know, Amazon did. Amazon was a corp the whole time. Some of them stay passed through.

Matthew Foreman [00:17:29]:
You know, so it depends, right? You want to show a pattern, you want to show a long term plan. There’s a great one. 1988 case, Bentley TC Mellow. 1988, 444. The 1988 Bentley. Mr. Bentley, I assume, spent $5,000 to travel in Europe. Remember 1988.

Matthew Foreman [00:17:48]:
We’re getting on 40 years ago, which is depressing to think about. And he sold pictures that he took for $30. So like he spent five grand. You have to sell a lot of pictures to make back five grand at 30 bucks. Clip, right? So they were like, ah, we don’t really think this is. There’s a fortuitous or unforeseen circumstances, right? Drought, bad timing, pandemic, the market crash, death of a manager or partner, theft. Those could actually be really good ones. You can say, look like I just, I had a really bad run this time.

Matthew Foreman [00:18:23]:
My, my partner died. This time there’s a global pandemic. Yeah, maybe that could work. That could really work. Number seven, profits actually earned and the possibility of ultimate, ultimate profit. So infrequent and small profits. That’s bad. Artificial profits are cases where people will use timing mechanisms to pay income tax in one year.

Matthew Foreman [00:18:48]:
Especially when you could carry back losses or carry Back income or you know, carry back losses. Can’t do that anymore. Obviously where they would sort of time out, you know, cash accrual, stuff like that, that’s bad. They found them occasional but very large profits is good. This is where the horse stuff really works, right? The people who look, you know, I lost $10,000 a year for, for eight years, that near nine, I made $850,000. Right. That’s a, that’s a good fact pattern. That’s why, you know, I pick on horse cases.

Matthew Foreman [00:19:19]:
But they’re, they’re an issue. That, that’s why they’re tough, you know. So I think that that’s really important. The expectation of ultimate profit is if, if the expectation of ultimate profit is wholly unrealistic. Okay, that’s quote, wholly unrealistic. And there’s no profit motive. So it must be a somewhat realistic profit motive. It could say, well I don’t think it’ll happen, but who knows? Stettner, Stettler, stettler.

Matthew Foreman [00:19:44]:
I think TC memo 2017113 Antonides 91 TC 6854 circuit affirm that one. That one was about yacht chartering as we’ll get into in the next one. The IRS becomes extremely dubious of any situation involving super wealthy people who really don’t seem to care if they lose money on a hobby business. They’re really dubious of that. So there must be, there cannot be a wholly unrealistic expectation of privacy. I’m sorry, of profit. Fourth Amendment in there. Number eight, the taxpayer’s financial status.

Matthew Foreman [00:20:17]:
I’m going to be honest, I hate this one. I’ve never liked it. The cases here are troublesome because they’re people who really have other bad fact patterns. But they bring this one in. This is one where the ones that lose have bad fact patterns. And simply being wealthy doesn’t mean you’re not trying to make more money. Right. The lack of other income or assets suggests that the person is trying to make money.

Matthew Foreman [00:20:39]:
Nickerson, 700 thing 700 fed. 2nd 427 circuit which actually reverse the tax court. So lacking money and lacking assets and income suggests you’re trying to make money even if you are offsetting your other income, your spouse’s other income, whatever, then you know, it just. Candidly, I think it looks overly critically at wealthy individuals and perhaps incorrectly so. But they should look, they have money to have a hobby, so why should the government subsidize them? You know, maybe the government shouldn’t allow them to use their losses to offset other income they should just go away. They should just never be able to use the losses. And that’s a policy question. I’m always bothered when treasury regulations create policy.

Matthew Foreman [00:21:20]:
I’m less bothered by Congress, although candidly, I actually think the Treasury Department and the IRS are better at it than the Congress and Congress that’s not so good at it. But I think it’s, it’s, it’s. It’s kind of important to note that, you know, maybe this is why. Maybe that’s why this should be a factor. And it’s important. And nine, we’re going to, we’re going to go to the last one here. The elements of personal pleasure, recreation. Why can’t your business, you know, I always ask question, why can’t your business be something you enjoy? It’s an intentionally tough factor.

Matthew Foreman [00:21:49]:
It focus the focus your efforts in audit defense on the other ones. I think it’s really important. I like being a tax lawyer. I mean, I’m not losing money on it, but you know, theoretically you could start a law firm and lose money for a while. If you’re losing money as a lawyer, maybe you’re doing some stuff wrong, but you know, that, that can be tough. But the key for this one is looking at personal motives. And the business is something that’s often done as a recreation. And I think that’s really important.

Matthew Foreman [00:22:16]:
Simply enjoying your, your work doesn’t really matter as much, but it’s like, you know, racing horses, collectibles, stuff like that. I keep going for it, and I think that’s an important one to do. All right, we’re a little longer than I wanted, but we’re gonna take one more music break, come back, talk about a little bit of gambling, and then. And close this up. So be right back. One thing before I get into gambling and come back, obviously there’s a lot of cases involving people who have like home recording studios for music, music’s a big one, stuff like that, that are sort of like someone’s dream to do and that. That’s where they come in. Right? That’s where horsing horses, races, racing, stuff like that.

Matthew Foreman [00:23:24]:
Racing cars really can be big and collectibles. Right. You know, people like, well, I lost money and you know, do you. Are you really selling? Are you selling? Occasionally? Well, how does that work? Right. Anyway, so gambling has two really interesting cases. When I talk about a lot what I haven’t, and I’m going to, I’m going to butcher the name, but it’s tschet s c h o t chat shot I’m not totally sure. TC memo 2007 38. He.

Matthew Foreman [00:23:47]:
He was a card counter for blackjack. Okay, so the dude came out as a card counter, okay? He clearly wasn’t good at it. Good enough at it because he lost money and had to deal with the hobby loss rules under 183. So he was a card counter and he took. He was taking precautions, man. He was. He had a mechanical system. He did this, he did that.

Matthew Foreman [00:24:13]:
He was so good at. He had a way of doing it. And he lost money. Okay, so is playing poker generally a business? No, he was taking the position that because he was counting cards that it was a business. But remember, and I said this with a small chuckle, he lost money. So clearly he was not good enough at it. That was it. Grozinger again.

Matthew Foreman [00:24:39]:
Dog races. I mean, he was systematic. He quit his job, he did it, he lost a couple thousand dollars. Great case law for taxpayers. Mr. Grossinger was not good at business. That was a problem. So, all right, that.

Matthew Foreman [00:24:53]:
That’s. That. That was episode 49. Can’t believe we’re at 49 of how tax works. Hope you learned something. I’ll be back in two short weeks or two long weeks, depending on when spring gets here. With the 50th episode, we’re coming up on two years and I’m going to talk about either scam loss deduction, scam losses and the ability to deduct them, or maybe you saw a special one on sales and use taxes and registering cars in Montana. It’s a question of whether I get my act together and what the order will be.

Matthew Foreman [00:25:21]:
So you’ll find out in two weeks. And now for the best song of all time. Thanks for listening.