The Treasury Inspector General for Tax Administration has issued a report and found that the IRS has been delinquent in reviewing “hobby losses” on high-net-worth individuals who claim a Schedule C (or similar form) loss as a second business. The report goes on to say that when tax returns containing potential hobby losses are selected for audit, the examiners do not always address the hobby loss issues.
The Treasury Inspector General evaluation of data from 2013 identified approximately 10,000 individuals who claimed a Schedule C loss of at least $20,000 with gross receipts under $20,000 and reported wages of at least $100,000. These same Schedule C businesses also reported losses in four consecutive years. Also, approximately 7,500 of these Schedule C businesses were found to be using “hobby” loss expenses inappropriately to reduce taxes by as much as $70 million for tax year 2013.
Section 183(a) of the Tax Code generally disallows business tax deductions for activities “not engaged in for profits” and Section 183(d), also referred to as the hobby loss provision, provides a presumption that most activities are engaged in for profit if the activity is profitable for three years of a consecutive five-year period (two years of seven consecutive years for breeding, training or racing of horses).
“Taxpayers with significant amounts of income from other sources may attempt to reduce their tax liability by including losses from activities not engaged in for profit” was the conclusion of the report. “The IRS needs to effectively identify these taxpayers in order to defer future non-compliance.” Recommendations from the report were that the IRS should make use of research capabilities in the Small Business/Self-Employed Division to identify high-income individual returns with multiyear Schedule C losses and other factors that indicate the taxpayer may not have a profit or capital gain motive for the activity.
The IRS has agreed with the recommendations and plans to take corrective actions. The IRS did disagree with the estimates provided in the report by saying that the IRS, not the taxpayer, bears the burden of proving that the taxpayer does not have a profit motives and therefore identifying returns with limited gross receipts, repetitive losses, and income from other sources is not sufficient to conclude that an activity was not engaged in for profit.
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