The Tax Code has long incentivized taxpayers to start or invest in a trade or business by giving various tax incentives in the form of special deductions, credits, and exemptions. However, such special treatment of business income and loss is subject to restrictions that business owners and investors must be wary of to avoid scrutiny from the IRS.
The Hobby-loss Rules:
Many Americans enjoy hobbies that are also a source of income for them. These can include a wide array of activities such as creating art, baking cupcakes, or training horses. The distinction between hobby income and business income is an important one because the IRS only allows losses for a limited amount of years. Consistent losses over several years may result in your business to be treated as a hobby by the IRS. Since hobbies are usually done for enjoyment more so than for profit, the IRS employs a test that focuses on profitability. If you have turned a profit in the last three out of five years, you will be considered to have business income. If you have been unprofitable for three or more years out of the last five, you will be considered to have hobby income IRC § 183(e)(2).
Flipped Real Estate Flipper:
In a recent 2018 Tax Court case, Homayoun Samadi, TC Summ. Op. 2018-27 (Tax Ct.), the IRS relied on the hobby-loss rules when it refused to allow a taxpayer’s business losses because he had collected no income for several years. The case involved a taxpayer that was a licensed real estate agent in California who was in the “business” of flipping houses together with his friends and family. The group intended to buy homes, renovate them, and sell for a profit. Over the course of several years the taxpayer would drive the members of his group about 192 miles a week between different cities in California to “scout” potential investment properties. They had never actually invested in a property. The taxpayer deducted on his federal tax returns the costs he incurred for travel and other expenses, and the IRS challenged these deductions in Tax Court. The taxpayer lost the case because it was found that he did not own a trade or business, and the Court demanded the reversal of the business deductions which totaled over $35,000.
In re “House Flipping activity wasn’t a trade or business,” Thompson Reuters Tax & Accounting, Practitioner’s Tax Action Bulletins No. 2018-11/Page 2; Homayoun Samadi, TC Summ. Op. 2018-27 (Tax Ct.).
How to Protect your business:
This case is a cautionary tale for taxpayers that wish to take advantage of the IRS’ generous treatment of U.S. business activity. The Hamayoun case makes clear that business owners are not always afforded the luxury of deducting losses for extended periods of time. If your business has not been profitable for several years, or if you are unsure about the tax consequences of your business operations, it is critical that you re-evaluate your business model with a tax professional to ensure that the IRS will not invite you to Court. In addition to offering such tax planning services, my law firm has also successfully defended business owners that have already attracted unwanted attention from the IRS.
If you have any questions or wish to learn about how to protect your business, call The Law Offices of Daniel M. Silvershein at 1(212) 387-7880, or email me at daniel@dmsilverlaw.com. We offer a free-of-charge thirty-minute consultation to help clients better understand how they can shield their business from the IRS.