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HOBBY LOSS RULES - OVERVIEW

In general, taxpayers may deduct all the ordinary and necessary expenses attributable to a trade or business or an activity engaged in for the production of income or for profit. And, generally, where expenses exceed the income from an activity, the deduction of the expenses creates a loss that may offset the taxpayer's income from other sources.

However, this is in contrast to the rule for activities not engaged in for profit, for in those cases, no deduction is allowed for expenses except to the extent of income from the activity. Code Section 183. The legislative history of the section indicates that one of the motivating factors behind its passage was Congress' desire to create an objective standard to determine whether a taxpayer was carrying on a business for the purpose of realizing a profit or merely attempting to create losses to offset other income. Congressional concern stemmed from a recognition that
"wealthy individuals [had] invested in certain aspects of farm operations solely to obtain 'tax losses' -- largely bookkeeping losses -- for use to reduce their tax on other income."

Code Section 183 is not strictly a disallowance provision because it allows a taxpayer to deduct some expenses that, because the taxpayer is not engaged in a trade or business or an activity for the production of income, could not otherwise be deducted. For these purposes, an activity not engaged in for profit is any activity other than one with respect to
which deductions are allowable for the tax year under either Code Section 162(a) (trade or business expenses); or Code Sections 212(1) or (2) (expenses paid or incurred for the production or collection of income or for the management, conservation, or maintenance of property held for the
production of income). Code Section 183(c). However, the deduction is limited to the income generated by the activity. Code Section 183(b).

PRACTICE TIP: The hobby loss deduction is further limited in that an adjustment to gross income (AGI) for a trade or business expenses under Code Section 162 is not available. Rather, the deductions allowed under Code Section 183(b) are classified as itemized deduction subject to applicable limitations. Purdy v. United States, 39 Fed. Cl. 413 (1997). To the extent that the deductions are miscellaneous itemized deductions, they are subject to the 2 percent of AGI limitation. See Section 49.5 Also, the deductions cannot be used in computing the alternative minimum tax.

Individuals, estates, trusts, S corporations, and partnerships are subject to the application of Code Section 183.

This chapter is divided into the following sections:

Section 49.2 Activities Not Engaged in for Profit;

Section 49.3 Factors Indicating a Profit Motive;

Section 49.4 Tax Avoidance Considerations;

Section 49.5 Deductions Allowable Under Code Section
183;

Section 49.6 Presumption of a Profit Motive and Election
to Defer Determination;

Section 49.7 S Corporations and Partnerships.