Versus Deductible Expenses
- 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
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.
IRS uses to determine if an activity is engaged in for profit
the time and effort put into the activity indicate an intention
to make a profit?
the taxpayer depend on income from the activity?
is the history of income or loss from the activity over the
past several years?
the taxpayer carry on the activity in a businesslike manner?
the taxpayer have the knowledge to carry on the activity as
a successful business?
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.
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.
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.
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.
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.
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.
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.)
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.
for Other Businesses
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.
must follow detailed recordkeeping and accounting practices to
demonstrate that their activities are directly related to a business
Wilson, CPA, MBA, JD, is a principal at the firm Rothstein
Kass, New York, N.Y.