Even the IRS Sometimes Has Trouble with the Business/Hobby Guidelines

In a case that is either ironic, or a case of foxes guarding the henhouse (or both), an IRS auditor was himself audited and expenses disallowed when his greyhound racing business was found to be a hobby.

We’ve talked in the blog and the Forum about the differences between a hobby business and a real business. A hobby business is one where you have no profit motive and take no steps to create one. You can make as much money as you want in a hobby business, but you may only deduct expenses up to your income threshold. You can’t run at a loss with a hobby business. The best you can do is break even.

In this case, the IRS applied their 9 Factor test to the auditor in question and came up short.

Factor 1: Businesslike Manner.

He had failed to carry on the activity in a businesslike manner. The business records were incomplete and inaccurate, he had no business plan, and no budget for his activity.

Factor 2: Prior Experience/Knowledge

While the taxpayer did have some knowledge about greyhound breeding and racing, he couldn’t show that he’d done any work to learn more about his business, particularly where the economics were concerned. He also couldn’t prove that he’d consulted with any other experts to increase his economic knowledge.

Factor 3: Dependence on Income Stream

The taxpayer did breed enough litters during the year to make a profit, but he wasn’t dependent on the income. He was still a full-time employee (for the IRS) during the audit period. This factor isn’t enough to lose the argument, but it will weaken it, which is why it’s so important to meet as many of the 9 Factors as possible.

Factor 4: Profit Motive

In 10 years, the taxpayer had failed to make a profit. Even though he made money in the business each year, the deductions (including depreciation on the racing dogs themselves) kicked him into a loss each year. Again, this isn’t a factor that by itself tips the argument, but as you add in the other failures, it becomes harder and harder to show that you are truly engaged in the business activity for profit.

At the end of the day the auditor (who was now a former auditor) was hit with a hobby determination, and a large tax bill for the substantial understatement of tax over the 10 year period.

The court also noted that, as a former IRS auditor, he should have known better. In a sense that was the 10th factor … and possibly the one that decided it all.

If you’re looking for Diane today (or anyone else in Phoenix), you may not find her. Phoenix was hit with a massive storm last night, featuring torrential rain, winds of up to 100 mph and thousands of lightning strikes. Large parts of the city are without power. In Diane’s case, her house has also been partially remodeled by a tree that came to visit during the night. No injuries, but lots of mess to clean up.