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The Test for Profit Motive: Allowance of Deductions under IRC § 183 Test

What factors aid the Tax Court in deciding when an activity is entered into with a “profit motive” (with allowable ordinary and necessary expenses) versus a hobby (where losses may be taken only up to the amount of profit received)?

Taxpayers can deduct all ordinary and necessary expenses paid or incurred in carrying on a trade or business,[1] for the production or collection of income,[2] or for the management, conservation, or maintenance of property held for the production of income.[3] Nevertheless, before engaging in the “ordinary and necessary” inquiry, taxpayers must pass the IRC § 183 test.

IRC § 183(a) generally disallows any deduction attributable to an activity “not engaged in for profit,” and is aimed at disallowing the deduction of the expenses of a hobby that a taxpayer might try to use to offset taxable income from other sources. In turn, IRC § 183(c) defines an “activity not engaged in for profit” as “any activity other than one with respect to which deductions are allowable for the taxable year under IRC § 162, IRC §§ 212(1), or IRC § 212(2). An activity does not need to show a profit, but taxpayers must have an actual and honest objective of making one,[4] and this expectation need not even be reasonable.[5]

The test of profit motive is a subjective one—a taxpayer must show that he undertook the challenged activity with an “actual and honest objective of making a profit.[6] The taxpayer’s expectation of profit doesn’t have to be reasonable, “but it must be genuine.” Indeed, Treas. Reg. § 1.183-2(a) notes that it may be sufficient that there is a small chance of making a large profit.[7] A taxpayer bears the burden of proving his motive, which must be to make an economic profit and not just to cut his tax bill.[8]

The Treasury Regulations provide guidance, observing that courts should apply objective standards to discern a taxpayer’s intent, taking into account all facts and circumstances.[9] To this end, the Treasury Regulations provide nine factors to consider, with no one factor being determinative.[10] Courts may look to other factors, and a determination should not be made based on the number of factors indicating a lack of profit motive and vice versa.[11] In determining whether the requisite intention to make a profit exists, greater weight is to be given to the objective facts than to the taxpayer’s self-serving characterization of his intent.[12]

The Nine Factors

Factor One: Manner in Which the Activity Is Conducted

The first factor examines how the taxpayer carries on the activity. A taxpayer who works in a “businesslike manner” and “maintains complete and accurate books and records” is more likely to have a profit motive than one who merely seeks to “get better” and “win” and who fails to adequately keep separate books and records, as in the present case.[13] Profit motive may also be found “where an activity is carried on in a manner substantially similar to other activities of the same nature which are profitable.”[14]

Without adequate recordkeeping, it is quite difficult for a taxpayer to evaluate economic performance and ways to improve profitability.[15]  The Tax Court has historically been lenient with respect to recordkeeping, holding that even informal recordkeeping is sometimes enough to help show a profit motive,[16] but the taxpayer’s system must at least provide “the minimum financial information necessary” to make business decisions.[17]

Finally, it should be noted that a business plan based solely on “winning” is not an actual business plan – much to the chagrin of the petitioner in Gallegos v. Commissioner,[18] Charlie Sheen, and the hashtag that will long outlive both of them.[19]  Ultimately, the Tax Court found that “winning” team roping competitions was more of a hope than a real business plan.[20]

Factor Two: Expertise of Taxpayers or Advisers

Next, the factors look to whether there was preparation for the activity by extensive study of its accepted business, economic, and scientific practices or consultation with experts, both of which suggest a profit motive.[21] While a taxpayer needn’t make a formal market study in preparation for a trade or business, he’s expected to undertake a basic investigation of the factors that would affect his profit.[22] Technical knowledge of the activity itself, apart from its economics, is insufficient.[23] Favoring technical knowledge over practical knowledge of an activity’s economics reveals a skilled hobbyist and not a businessman.[24]

Factor Three: Time and Effort Expended on the Activity

The fact that the taxpayer devotes much of his personal time and effort to carrying on an activity, particularly if the activity does not have substantial personal or recreational aspects, may indicate an intention to derive a profit.[25] A taxpayer’s choice to leave another job to spend most of his time on the activity may be very convincing evidence of his intention to turn a profit, but it is not, itself, dispositive.[26]

Activities with substantial personal or recreational aspects neutralize this factor. Indeed, the Tax Court has previously held that the time and effort factor is “neutral” for taxpayers who “also derived substantial recreational benefit from the time they spent with their horses,” even given the work associated with the activity.[27]

Factor Four: Expectation That Assets Used in Activity May Appreciate in Value

An expectation that assets will appreciate in value can suggest a profit motive even if the taxpayer derives no profit from current operations.[28] The Tax Court will only infer a profit motive if a taxpayer expected that the asset’s appreciation would exceed their operating expenses, such that the eventual gain on sale would allow them to recoup their losses.[29] The fact that the asset in question loses value over the years and is ultimately sold at a loss, likewise cuts against the taxpayer’s argument.[30]

Factor Five: Success in Carrying on Other Similar Activities

A taxpayer’s previous success in similar activities may show that he has a profit objective, even if the activity is currently unprofitable.[31] Curiously, success in the insurance industry does not correlate to success in team roping events—so said the Tax Court.

Factor Six: History of Income or Loss

A series of losses during the startup stage of an activity may not necessarily prove that an activity is not engaged in for profit.[32] However, where losses continue to be sustained beyond the period which customarily is necessary to bring the operation to profitable status, losses may indicate that the activity was not undertaken for profit.[33] The regulations provide that a series of losses beyond the start-up stage may be indicative of the absence of a profit motive unless such losses can be blamed on unforeseen or fortuitous circumstances beyond the taxpayer’s control.[34]

Factor Seven: Amount of Occasional Profits, if Any

Occasional profits can show a profit motive, but the size and frequency of profits relative to losses are what matter.[35] Further, an occasional small profit from an activity generating large losses, or from an activity in which the taxpayer has made a large investment, would not generally be determinative that the activity is engaged in for profit.[36]

Factor Eight: Taxpayer’s Financial Status

A taxpayer’s lack of substantial income or capital from sources other than the activity at issue may indicate that the activity is engaged in for profit.[37] However, when a taxpayer is independently wealthy, the Tax Court has not historically applied this factor in the taxpayer’s favor.[38]

Factor Nine: Elements of Personal Pleasure or Recreation

The presence of personal motives in carrying on of an activity may indicate that the activity is not engaged in for profit, especially where there are recreational or personal elements involved.[39] The Tax Court observed that many hobbies can take a lot of time and energy while still being mostly a source of personal recreation.[40] Where the possibility for profit is small, and the possibility for gratification is substantial, the Tax Court has historically found that the latter possibility (gratification) constitutes the primary motivation for the activity.[41]  The gratification derived from an occupation worth doing, possibly beneficial to others, and probably requiring long hours of arduous labor must still not be confused with an intention to return a profit.[42]

Presumption of Profit Motive

The Code provides a rebuttable presumption whereby the Tax Court will “presume” that an activity is carried on for profit if the gross income derived from the activity exceeds the activity’s deductions for three of the last five years.[43]  For purposes of this test, deductions are determined without regard to whether or not the activity is engaged in for profit.[44] The presumption is rebuttable, meaning that once the taxpayer demonstrates profit for three of the last five years, the burden shifts to the IRS to show that the activity was not engaged in for profit under the nine-factor test set forth above.

Under the regulations, the presumption applies only for the third profitable year and all subsequent years within the five-year period beginning with the first profit year.[45] This is best illustrated through an example.[46]

Example: Uncle Bill was not always a successful emu farmer. In the beginning, he struggled to determine how best to make his favorite hens, Marlene and Darlene, lay eggs consistently.  Though he varied their diets during his first few years, it wasn’t until Marlene got a certain twinkle in her eye as Bill was humming “The Way You Look Tonight,” that the emu farm went gangbusters.  Now, when it’s egg laying time, Bill serenades Marlene, Darlene, and the eight other hens with the dulcet tones of Sinatra and Sammy Davis, Jr. (but never Dean Martin—Bill has his reasons)).

Stunning Sheila’s (Bill’s emu farm) had a loss in year 1, 3, and 6, with profits in years 2, 4, 5, 7, and 8.  He notes that year 6 was an outlier, because Marlene and Darlene had gotten into some sort of emu-tiff and refused to be in the same room together, meaning that neither was a regular egg layer.  Looking at the Treasury Regulations, the first five-year period would begin in year 2, the first profit-making year.  The benefit of the presumption does not kick in until year 5, the third profit year.  The presumption would not apply in years 2, 3, or 4, because it does not apply until the third profitable year during the five-year period.  As such, the presumption would apply to years 5 and 6.  A second five-year period begins with the second profitable year (year 4) and runs through year 8.  Thus, the presumption would attach for years 7 and 8.  Taken together, Bill can avail himself of the presumption of profit in years 5, 6, 7, and 8.

A taxpayer may elect to delay the testing period until the fifth year in which the taxpayer is engaged in the activity by filing a Form 5321 with the IRS within three years after the non-extended due date of the return for the first taxable year in which the taxpayer engages in the activity.[47] However, in doing so, the taxpayer agrees to the automatic extension the statute of limitations for all years in the postponement period until two years after the due date of the return for the last year of the postponement period.[48] This automatic extension applies, however, only to a deficiency attributable to the activity and does not extend the statute of limitations for unrelated items.[49]

Commentators note that it is exceptionally rare, and often misguided, to make such an election.  In making the election, the taxpayer tips off the IRS that there is a potential profit-making issue, which greatly increases the chance that the IRS may scrutinize (audit) the activity. Further, if the presumption is not met, the taxpayers will have both alerted the IRS and may have a substantial tax deficiency for all years.  There are benefits—resolving audits of earlier years or avoiding litigation—but a cost benefit analysis should be made before the election is made.

Aggregating Hobbies for Loss Purposes

Martens – Shiftiest of the Weasels

Though Uncle Bill is an idiot-savant when it comes to flightless birds, his abbreviated attempt at breeding pine martens for sale to the fine folks in New Hampshire, who could use them as they saw fit, though he hoped that they would introduce the weasel-like animals into the wilds (where they are considered a “threatened” species), was nothing short of a bloody disaster.  Bill had a certain je ne sais quoi when it came to emus.  They could be ornery and mean as a Florida black snake on a tar roof in August, but when Bill was around, they were like fawning two-legged, feathered puppies.  Nevertheless, his husbandry was not met with approval from the seven pairs of breeding martens he trapped in the Northwoods and brought to his farm.

The viciousness of the weasel family should never, ever be underestimated.

Later research would inform Bill that American martens are extremely solitary creatures, who only interact with each other to breed or fight about breeding.  Having fourteen sex-crazed martens in forced proximity consequently led quickly to a reduction in Bill’s breeding population.  Despite the males being much larger, in the end, he was left with one angry, pregnant female, who he named Carole—after his sister-in-law, of whom the marten reminded him so very much.  Whether Bill let Carole escape or whether she figured out how to jimmy the door to her enclosure is a subject of much debate, but in the end, Bill considered this a real loss—for tax purposes.  (He wouldn’t miss Carole’s beady little eyes.)

Where a taxpayer is engaged in several undertakings, as Bill was with his emu farm and marten experiment, each activity may be a characterized separately, or several undertakings may constitute one activity. In ascertaining the activity or activities of the taxpayer, all the facts and circumstances of the case must be taken into account.[50] Generally, the most significant facts and circumstances the IRS and Tax Court use to make this determination are the degree of organizational and economic interrelationship of various undertakings, the business purpose served by carrying on the various undertakings, and the similarity of various undertakings.[51]

Although the IRS “will accept the characterization by the taxpayer of several undertakings as a single activity,” it will not accept the characterization when it “appears…artificial and cannot be reasonably supported under the facts and circumstances of the case.”[52]  If the taxpayer engages in two or more separate activities, deductions and income from each separate activity are not aggregated either in determining whether a particular activity is engaged in for profit or in applying IRC § 183. However, if the taxpayer is engaged in multiple activities that may be aggregated, an item of deduction or income may be allocated between such activities.

Many cases have been decided on this aggregation issue. The Tax Court is not inclined to allow the aggregation, when the two activities are connected by a tenuous thread spun by the taxpayer’s testimony alone. For instance, a lawyer who also bred and sold polo ponies could not aggregate the two activities.[53] Nor could a doctor who played polo aggregate his medical practice and his polo endeavors.[54]  In both cases, the question arises as to whether the lawyer and doctor could have aggregated the two dissimilar activities if they had kept better records of the relationship from the activities’ inception.  Finally, a dentist who also owned an apple orchard could not aggregate the two activities, even though he argued that he could not practice “holistic dentistry” without the orchard.[55]  Because the dentist’s apples were available only during growing season, and the dentist worked on teeth year-round, the Tax Court determined that the dentist could practice without the aid of apples. However, freehand structural design and equestrian activities could be aggregated, so long as the connection was properly…drawn.[56]

Poodle breeding and dog grooming could be aggregated, in part because when you bought a poodle, you agreed to have it groomed by the taxpayers.[57] Owning a farm and breeding horses, similarly, may be aggregated.[58]  In this latter case, the Tax Court held that They were both done on the same land; both were attempts to generate income from the farm; some of the same assets were used for both businesses; the rodeos were used to advertise and sell the horses raised on the farm; the same accountant and the same checking account were used for both businesses; and both activities were reported on the same schedule each year.[59]  It’s important to note, here, that one way to build a stronger case for aggregation of activities is to report all activities on a single Schedule C (Profits and Losses from Business) each and every year.

The Tax Court has historically applied various factors in deciding whether a taxpayer’s characterization of several undertakings as one activity is unreasonable for purposes of IRC § 183,[60] such as:

    • Whether the undertakings share a close organizational and economic relationship;
    • Whether the undertakings are conducted at the same place;
    • Whether the undertakings were part of a taxpayer’s efforts to find sources of revenue from his or her land;
    • Whether the undertakings were formed as separate businesses;
    • Whether one undertaking benefited from the other;
    • Whether the taxpayer used one undertaking to advertise the other;
    • The degree to which the undertakings shared management;
    • The degree to which one caretaker oversaw the assets of both undertakings;
    • Whether the taxpayers used the same accountant for the undertakings; and
    • The degree to which the undertakings shared books and records.

Finally, in the Hoyle case, which is most similar to Uncle Bill’s situation, a taxpayer owned a farm on which he pursued many undertakings, including farming, hunting, crabbing, riding lessons, horse boarding, game-bird breeding, and thoroughbred horse racing.[61] The Tax Court found that all the activities occurred on the same land and that the same accountant maintained all the activities’ tax records. Though the taxpayer kept separate checkbooks for each undertaking, this alone did not indicate that he treated the activities separately—it was merely a common, simple way to keep income and expenses separate.

The Tax Court in Hoyle further held that because holding the land for appreciation was one of the activities, though the farming was not profitable, the two activities could be aggregated.  Importantly, the taxpayer’s primary intent was to operate a farm.  Holding the land for appreciation was incidental.  If he instead primarily held the land for appreciation, and just so happened to operate a farm that was not profitable, the result would be different under the regulations.[62]  If the farm were profitable, then the result would be the same with either intent.[63]

Bill’s distant cousin, Cletus

As a result of the Hoyle case, and other favorable cases with similar fact patterns (though not involving murderous martens), it is likely that Bill will be able to aggregate his pine marten activity with not only his emu farming activity, but also with the holding of the land for appreciation, which will enable Bill to take deductions such as interest on a mortgage secured by the land, annual property taxes attributable to the land and improvements, and depreciation of improvements to the land.  Thus, the blow from the loss of Carole and her fellow investment martens is significantly softened and all but forgotten when tax time rolls around when Bill can translate those emotional losses to losses from the conduct of an activity entered into for profit under Schedule C.


Footnotes:

[1] IRC § 162.

[2] IRC § 212(1).

[3] IRC § 212(2).

[4] Dreicer v. Commissioner, 78 T.C. 642, 645 (1982), aff’d without published opinion, 702 F.2d 1205 (D.C. Cir. 1983).

[5] See Treas. Reg. § 1.183–2(a).

[6] See Dreicer v. Commissioner, 78 T.C. 642, 645 (1982), aff’d, 702 F.2d 1205 (D.C. Cir. 1983).

[7] See also Elliott v. Commissioner, 90 T.C. 960, 970 (1988), aff’d, 899 F.2d 18 (9th Cir. 1990).

[8] Westbrook v. Commissioner, 68 F.3d 868, 876 (5th Cir. 1995), aff’g T.C. Memo. 1993-634.

[9] See Treas. Reg. § 1.183-2(a).

[10] See Treas. Reg. § 1.183-2(b); Allen v. Commissioner, 72 T.C. 28, 34 (1979).

[11] Id.

[12] Burger, T.C. Memo. 1985-523.

[13] See Treas. Reg. § 1.183-2(b)(1).

[14] Id.

[15] See Burger v. Commissioner, T.C. Memo. 1985-523, aff’d, 809 F.2d 355 (7th Cir. 1987).

[16] See Keenan v. Commissioner, T.C. Memo. 1989–300.

[17] Id.

[18] T.C. Memo. 2021-25.

[19] #winning.

[20] See Kneels v. Commissioner, T.C. Memo. 2017-152, *15.

[21] Treas. Reg. § 1.183-2(b)(2).

[22] Heinbockel v. Commissioner, T.C. Memo. 2013-125, *24-*25; Golanty v. Commissioner, 72 T.C. 411, 432 (1979).

[23] Metz v. Commissioner, T.C. Memo. 2015-54, *44.

[24] See Golanty v. Commissioner, 72 T.C. 411, 432 (1979), aff’d, 647 F.2d 170 (9th Cir. 1981).

[25] Treas. Reg. § 1.183-2(b)(3).

[26] See Metz, T.C. Memo. 2015-54, at *46-*47.

[27] See Dodge v. Commissioner, T.C. Memo. 1998-89, 1998 WL 88175, at *5-*6), aff’d, 188 F.3d 507 (6th Cir. 1999); Giles v. Commissioner, T.C. Memo. 2006-15, 2006 WL 237503, at *13.

[28] See Treas. Reg. § 1.183-2(b)(4).

[29] See Bronson v. Commissioner, T.C. Memo. 2012-17, *8, aff’d, 591 F. App’x 625 (9th Cir. 2015).

[30] Heinbockel, T.C. Memo. 2013-125 at *26.

[31] See Treas. Reg. § 1.183-2(b)(5).

[32] See Treas. Reg. § 1.183-2(b)(6).

[33] Id.

[34] Id.; Burger, T.C. Memo. 1986-523.

[35] See Treas. Reg. § 1.183-2(b)(7).

[36] Id.

[37] See Treas. Reg. § 1.183-2(b)(8).

[38] See, e.g., Heinbockel, T.C. Memo. 2013-125 at *11; Gallegos, T.C. Memo. 2021-25 at *23-24.

[39] See Treas. Reg. § 1.183-2(b)(9).

[40] See Betts, T.C. Memo. 2010-164 at *9.

[41] See Burger, T.C. Memo. 1985-523.

[42] White v. Commissioner, 23 T.C. 90, 94 (1954), aff’d, 227 F.2d 779 (6th Cir. 1955).

[43] IRC § 183(1).  For horse related activities, the test is for profit in two out of the last seven years.

[44] Id.  Further, the taxpayer excludes net operating losses in determining deductions. Treas. Reg. §1.183-1(c)(1)(ii).

[45] Treas. Reg. §1.183-1(c)(1)(ii).

[46] Adapted—loosely—from Treas. Reg. §1.183-1(c)(2), Ex. 1.

[47] IRC § 183(e).

[48] IRC §183(e)(4).

[49] See, e.g., Pruitt v. Commissioner, 63 T.C.M. 2628 (1992) (IRS can assess any deficiency attributable to an IRC § 183 activity since taxpayer, having made an IRC § 183(e) election, extended statute of limitations); TAM 8330002 (waiver of statute of limitations accompanying an IRC § 183(e) election extends period for assessment based on facts other than profit motive determination (disallowed part of auto-travel, depreciation, cost of goods sold, interest expense, and also to adjust gross receipts)).

[50] Treas. Reg. § 1.183-1(d)(1).

[51] Id.

[52] Id.

[53] De Mendoza v. Commissioner, T.C. Memo. 1994-314.

[54] Wilkinson v. Commissioner, T.C. Memo. 1996-39.

[55] Zdun v. Commissioner, T.C. Memo. 1998-296.

[56] Not sorry for the pun.  See Topping v. Commissioner, T.C. Memo. 2007-92 (finding that the taxpayer relied on contacts made at the club to advance her design business and finding that there was a close organizational and economic relationship between the two undertakings).

[57] Keanini v. Commissioner, 94 T.C. 41 (1990).

[58] Estate of Brockenbrough v. Commissioner, T.C. Memo. 1998-454.

[59] Id.

[60] Id. (citing Keanini, 94 T.C. at 46 (1990); Hoyle v. Commissioner, T.C. Memo.1994–592; De Mendoza, T.C. Memo.1994–314; Scheidt v. Commissioner, T.C. Memo.1992–9; Trafficante v. Commissioner, T.C. Memo.1990–353; Schlafer v. Commissioner, T.C. Memo.1990–66).

[61] Hoyle v. Commissioner, T.C. Memo. 1994-592.

[62] Treas. Reg. § 1.183-1(d)(1).  Where land is purchased or held primarily with the intent to profit from increase in its value, and the taxpayer also engages in farming on such land, the farming and the holding of the land will ordinarily be considered a single activity only if the farming activity reduces the net cost of carrying the land for its appreciation in value.

[63] Id. The farming and holding of the land will be considered a single activity only if the income derived from farming exceeds the deductions attributable to the farming activity which are not directly attributable to the holding of the land.

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