If your entrepreneurial spirit has led you into some less-than-profitable business activities, you should be aware of how the “hobby loss” rule could affect your tax deductions.
The Tax Court has recently denied most of the deductions associated with several purported business activities engaged in by Ed and Linda Heinbockel (Heinbockel v. Commissioner, TC Memo 2013-125, May 13, 2013).
Under the so-called hobby loss rule, deductions attributable to an “activity not engaged in for profit” are allowed only to the extent of income from that activity, or to the extent deductions are allowable regardless of any profit-seeking motive, whichever is larger. The regulations list nine factors to consider in determining whether the profit motive is present:
- Manner in which the taxpayer carried on the activity
- Expertise of the taxpayer or his advisers
- Time and effort expended by the taxpayer in carrying on the activity
- Expectation that assets used in the activity may appreciate in value
- Success of the taxpayer in carrying on other similar or dissimilar activities
- Taxpayer’s history of income or losses with respect to the activity
- Amount of occasional profits, if any, that are earned
- Financial status of the taxpayer
- Presence of personal pleasure or recreation
Ed and Lydia Heinbockel are, as described by the Tax Court, “a happy couple possessed by entrepreneurial spirit.” During 2005-2007, Ed worked full-time running a successful company, and Lydia ran a personal shopping business called Lydia’s World. They claimed many deductions in association with Lydia’s World, and they also claimed significant losses during those years from three other activities.
Collective Flight was Ed’s “one-airplane transport company” for which Ed purchased a plane in 2004, supposedly for business purposes. However, his loan agreement indicated that Ed bought the plane for personal use. He seldom actually used it for business trips and had no other clients. His reported revenue from Collective Flight was $4,000 in 2005, $30,000 in 2006, and $6,000 in 2007, but the expenses for each year ranged from approximately $45,000 to $100,000.
Also in 2004, the Heinbockels bought property in wine country to build a home and establish a vineyard. They hired an architect and purchased a tractor to grade the land but faced legal opposition from their neighbors and the county.
Although they eventually got a permit to establish a vineyard, they never actually planted a single grapevine and sold the property in 2007. They reported losses of $49,000 in 2005, $13,000 for 2006 and $8,000 for 2007.
The Heinbockels reported a net loss in 2005 from a “residential rental.” However, they didn’t own the property. It was owned by Lydia’s brother, to whom Lydia lent money for rehabilitating the property.
The property ultimately was abandoned, and Lydia, who became involved in a lawsuit over the property, hired attorneys to recover some of the borrowed money. She eventually received a $230,000 award, which the couple reported as an overall $25,784 loss on their 2005 Schedule E. But at trial, they argued that they had a lending-activity loss of $11,884 that should have been reported on Schedule C.
In disallowing most of the deductions related to the above activities, the Tax Court concluded that the Heinbockels had no profit motive with respect to the aircraft, there was no grape farming “business,” there was no lending business with respect to the residential rental loan, and the Lydia’s World expenses were largely personal.
The Tax Court upheld the IRS’s substantial understatement of tax penalty for each year.