By: Juliya Grigoryan, Staff Member
Apparently, one way to ensure an above-the-line (most favorable) deduction on your taxes is to spend an insatiable amount of time, energy, and money at a “trade or business” you don’t enjoy. Disclaimer—this sentiment is not related verbatim from the tax code. Nevertheless, it is true that a § 162 above-the-line deduction is only available for “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business [emphasis added].”[i]
One of the pertinent evaluations in determining whether an expense arose out of a trade or business, rather than a mere hobby, is the taxpayer’s profit-seeking endeavors.[ii] This matters to the IRS because it wants to prevent taxpayers from simply disguising their hobbies (which are largely not deductible) as a trade or business for the purpose of minimizing their taxable income.[iii]
However, § 183 of the tax code provides for a rebuttable presumption that horse breeding is a for-profit activity if it generates a profit in two or more of the last seven consecutive years.[iv] If a profit is not generated within this time frame, a taxpayer can still make an argument that the activity was for profit.[v] Most recently, a case out of Illinois demonstrates a taxpayer’s attempt show that her horse breeding activity was for profit, despite not actually generating profit.
Estate of Stuller v. United States, concerns a taxpayer who in the mid-1980s decided to breed horses for profit, under the company name “Rockin S Ranch” (LSA). Unfortunately for her, the law inherently values substance over form.[vi] In other words, it matters little that she “cries profit!” if her actions would lead a court to believe otherwise. The court in this case looks at a variety of factors and ultimately determines that she was not breeding horses for profit, and thus, was unable to take § 162 deductions.[vii]
The “most important” factor, according to the court, is the “manner in which the taxpayer carries on the activity.”[viii] The court emphasizes that despite the taxpayer’s substantial losses, she did nothing to change her methods to yield more favorable results. She did not seek business advice or employ new marketing techniques.[ix] In fact, she did very little to market her business in the first place.[x] In a period of six years, she spent only $50 in marketing.[xi]
Another noteworthy factor is a taxpayer’s financial status.[xii] The fact that she was even in a position to claim $34,000 worth of losses per year, yet still be financially secure, would indicate that horse breeding was not her main source of income.[xiii] The court found that her primary source of income resulted from the ownership of three Steak n’ Shake franchises.[xiv] Although it is common for people to have multiple “trades or businesses” from which they derive income, it is unlikely for a court to find that a taxpayer entered into an endeavor for profit if they are content with constant losses.
What can be learned from this case? First, if your hobby is getting too expensive, creating a faux “business” for it will not redeem you any of the losses. Quit while you’re ahead. Second, the courts will look at many factors to determine whether conduct rises to the level of trade or business, and thus, the Section 183 presumption can be overcome. Last, apparently fast food franchises are incredibly lucrative businesses. Look into it.
[i] 26 U.S.C. § 162.
[ii] Estate of Stuller v. United States, No. 11-3080, 2014 WL 3734328, at *4 (C.D. Ill. July 22, 2014 (citing Nickerson v. Commissioner, 700 F.2d 402, 405 (7th Cir. 1983)).
[iii] See Id.
[iv] 26 U.S.C. § 183.
[v] 26 C.F.R. § 1.183-1(c).
[vi] Id. at *2.
[vii] Id. at *22.
[xi] Id. at *8.
[xii] Id. at *20.
[xiii] Id. at *12.
[xiv] Id. at *19.