Nondeductible Versus Deductible Expenses

By Mary Wilson

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SEPTEMBER 2007 - When does a pastime become a business? There is a fine line between a hobby that generates nondeductible expenses and the deductible expenses of a business. According to the IRS’s “Preliminary Data on Individual Income Tax Returns,” there were approximately 21 million individual returns filed for 2005 that reported business or professional activity, of which approximately 25% reported a net loss.

Tax deductions are limited by IRC sections 183 and 162. Under section 183, losses are deductible only if they are the result of a bona fide business that is engaged in for-profit activities. Under IRC section 162, expenses are deductible when they are “ordinary and necessary” for conducting a trade or business. An activity not engaged in for profit is a hobby. Whether a taxpayer’s activities are engaged in “for profit” and whether the expenses are “ordinary and necessary” will determine whether a taxpayer’s deductions will be allowed.

Factors the IRS uses to determine if an activity is engaged in for profit include:

  • Does the time and effort put into the activity indicate an intention to make a profit?
  • Does the taxpayer depend on income from the activity?
  • What is the history of income or loss from the activity over the past several years?
  • Does the taxpayer carry on the activity in a businesslike manner?
  • Does the taxpayer have the knowledge to carry on the activity as a successful business?

Topping

In Topping v. U.S. (T.C. Memo 2007-92), the U.S. Tax Court ruled in favor of a taxpayer who was an accomplished equestrian rider and deducted her equestrian losses against her interior-design business income. The IRS had disallowed the deductions on the grounds that the petitioner’s equestrian activities were unreasonable and were not ordinary and necessary because they represented personal expenditures of the taxpayer. The Tax Court, however, found that: 1) the equestrian and related activities were part of the design business, 2) the activities were conducted for profit, and 3) the equestrian-related expenses were ordinary and necessary.

The case involved a recently divorced woman named Topping with no means of independent support, a debt-laden condominium, and her 16-year-old horse. She had neither a college degree nor any full-time employment for the past 25 years. Topping supported herself by building a business designing horse barns and homes. Her plan was to develop a reputation among the wealthy families of the equestrian circuit who own multiple residences and use interior designers.

Topping did not have a written business plan, and did not conduct a formal market study. She used her home office to conduct all financial aspects of the design business. She possessed the artistic ability to draft structural designs freehand and used her specialized knowledge of the idiosyncrasies of her clients’ horses to tailor barn designs. Topping would analyze a horse’s particular injury or temperament and then design a barn with stalls suited to the horse’s individual needs. Some designs incorporated mudrooms and expanded storage for boots, saddles, and other equipment.

The taxpayer was an experienced equestrian, having ridden horses and competed on an amateur level since she was a teenager. Her contact list was developed by participating in these expensive equestrian activities. It was these expenses that were offset against the interior design business income on her tax return.

Most equestrian events are held at elite private clubs that are not open to the general public. Topping testified that she neither used traditional advertising media nor displayed banners at any equestrian event. She stated that this type of generic advertising of a personal service business would be considered tacky to a jockey club and its members. The petitioner relied upon her exposure and reputation as both a rider and owner, and also her popularity among the club members, to attract new clients.

When the IRS audited Topping, it segregated the equestrian from the interior design activities and disallowed all of the petitioner’s Schedule C horse-related expenses. The IRS reclassified the horse-related income from Schedule C to other income. The IRS decided that the horse-related expenses should be disallowed because the activity was not engaged in for profit and that some of the expenses were not ordinary and necessary.

Tax Court Decision

The Tax Court, however, found that a close organizational and economic relationship existed between the equestrian and design undertakings. The taxpayer’s success as an equestrian competitor created goodwill that benefited her design business. The court determined that the facts in the case supported a finding that the equestrian and design undertakings were to be considered a single activity, and that a significant business purpose joined both undertakings. Her prominence as a competitor gained her respect among her peers and caused them to seek her out when they needed a designer for their horse barns and recreational homes. (Interestingly, the petitioner filed two separate Schedule Cs for the years in issue, one for the equestrian business and one for the interior design business. The court commented that, regardless of this fact, the evidence proved that the two undertakings constituted a single activity.)

The court noted that the interior design business was a success and turned a profit almost every year. Therefore, the court found that the taxpayer clearly demonstrated an intent to make a profit and that she conducted her equestrian and related activities as part of her interior design business. Thus, the equestrian expenses could be deducted as ordinary and necessary. The design and equestrian activities were found to be part of an integrated business plan and the petitioner’s clientele was almost exclusively derived from equestrian contacts.

Lessons for Other Businesses

Although Topping is a positive ruling for taxpayers with hobbies that dovetail with their business plans, it should not be interpreted to mean that every hobby can be linked to a business. Remember the case of the CPA/attorney with the tax practice who tried to write off his yacht? He flew a red, white, and blue pennant with “1040” on it. His goal was to provoke inquiries and promote business by giving him contact with potential clients in yachting circles. The court held that the yacht expenses were not deductible as ordinary and necessary expenses of carrying on a business. He failed to show how any of his clients were referrals from his boating activities.

Taxpayers must follow detailed recordkeeping and accounting practices to demonstrate that their activities are directly related to a business purpose.


Mary Wilson, CPA, MBA, JD, is a principal at the firm Rothstein Kass, New York, N.Y.


 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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