Many of you are familiar with what are commonly referred to as the “hobby loss” rules. Section 183 of the Internal Revenue Code limits a taxpayer’s ability to deduct expenses associated with activities “not engaged in for profit.” The most common business activities that tend to raise this issue are those involving cattle and horses (e.g., breeding, racing, and showing), aircraft (e.g., leasing and chartering), yachts and boats (e.g., chartering, tours, and guides), hunting and fishing (e.g., lodges and guides), real estate rental (e.g., Airbnb and VRBO), woodworking, photography, and farming (e.g., aquatic, Christmas trees, vineyards, beekeeping, and cannabis).
While the question, for tax purposes, is typically whether the activities conducted by the taxpayer are a hobby or an actual business, in Gregory v. Commissioner, 122 T.C.M. (CCH) 227, T.C. Memo 2021-115 (Sep. 29, 2021), aff’d 2023 B.L. 182377 (11th Cir. 2023), the U. S. Tax Court recently addressed the nature of the allowable deductions when an activity is determined to be a hobby. In Gregory, the taxpayer conducted a charter boat operation and, for the tax years in question, reported gross income of $300,000 from the charter boat operation and deductions of slightly more than $300,000 attributable to the charter boat operation. The taxpayer actually conceded the charter boat operation was a hobby, but argued that to the extent the deductions offset the gross income (i.e., did not create a loss for income tax purposes), the deductions should be fully allowed.
The U.S. Tax Court disagreed. It held that, other than deductions allowed whether or not an activity is engaged in for profit (e.g., certain interest expense and real and personal property taxes), all deductions associated with the charter boat operation should be treated as itemized deductions and, more specifically, as “miscellaneous” itemized deductions.
The significance of the decision in Gregory requires a very brief diversion into the fundamentals of individual income taxation. Itemized deductions are, very generally speaking, those deductions that are not associated with a business activity or production of income. Unless the itemized deductions in question fall into one of twelve specifically enumerated categories, e.g., interest, taxes, charitable contributions, medical expenses, etc., they are treated as “miscellaneous” itemized deductions.
As a general matter, miscellaneous itemized deductions are deductible only to the extent they exceed two percent of the of the taxpayer’s adjusted gross income. That limitation, of itself, was sufficient to disallow all of the deductions in Gregory. Moreover, as part of the Tax Cuts and Jobs Act (P.L. 115-97), Congress entirely suspended deduction of miscellaneous itemized deductions for 2018 through 2025.
With this primer in basic income tax and based on the decision in Gregory, it becomes clear that the cost of an activity being characterized as a hobby loss is more significant than it appears. Between 2018 and 2025, a taxpayer who earns $300,000 gross income and incurs $300,000 expenses in a business activity ultimately determined to be a hobby under Section 183 of the Code, must report all of the $300,000 of gross income and deduct virtually none of the $300,000 of expenses. Those were the facts and that was the outcome in Gregory.
Gregory illustrates the importance of establishing a profit motive for business activities that are vulnerable to recharacterization as a hobby under Section 183 of the Code. Treasury regulations and courts consider several factors in determining whether an activity is engaged in for profit. Perhaps most importantly, a taxpayer should carry on the activity in a business-like manner (i.e., maintain accurate books and records, use a separate bank account, adhere to the legal formalities of the entity conducting the business, and adapt in order to make the business activity profitable). And, make use of the taxpayer’s expertise or that of a consultant. Experience suggests that a written plan to achieve profitability may be essential. While these steps may seem like window-dressing, they are critical, particularly if the activity is one that could be considered as recreational or enjoyable to the taxpayer. Moreover, the Internal Revenue Service or the court will inevitably look at the history of profits and losses associated with the activity. Losses during the start-up stage are not fatal and appreciation in the value of the assets may often overcome a history of losses. These are just some of the factors and, honestly, most of the factors reflect common sense business judgment but they are easy to neglect on a day-to-day basis.
Final words to the tax-wise? Given the outcome in Gregory, and the current bar on deducting “miscellaneous” itemized deductions, be aware that certain business activities are vulnerable to recharacterization as a hobby under Section 183 of the Code. If you are engaged in one of those business activities, visit with your tax advisor and, on a daily basis, take the steps he or she recommends to evidence your profit motive.
Jessica Lawson (2L, Harvard Law School) is a 2023 summer associate with McAfee & Taft. She holds an undergraduate degree in criminology and pre-law studies from the University of Oklahoma.