By George L. Yaksick, Jr., CCH Staff Writer
Tax officials carefully scrutinize many businesses to make sure their activities are truly for-profit, and therefore eligible for the tax rules that allow for writing off expenses and losses. The problem is, some taxpayers are really masquerading their hobbies and interests as business activities in order to offset their costs.
According to a recent government investigation, the IRS risks losing billions of dollars in revenue because the hobby loss rules are ineffective in deterring wealthy individuals from tax evasion. Nearly 1.5 million Schedule Cs filed over a recent four-year period showed no profits, only losses, the Treasury Inspector General for Tax Administration (TIGTA) reported in Significant Challenges Exist in Determining Whether Taxpayers with Schedule C Losses are Engaged in Tax Abuse. By claiming these losses, more than one million taxpayers potentially avoided paying $2.8 billion in taxes.
For example, in August of 2007, a federal tax court found that an IRS employee did not operate a basketball school with an actual profit motive. The school never earned a profit, the taxpayer had no expertise in basketball and he did not seek expert advice. The ruling stated that the traditional factors the IRS and the courts use to determine if an activity is a for-profit one were not present.
Presumption
Generally, the IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax tears, including the current year. The presumption is different for horse-breeding, showing, training, and activities where those activities are presumed to be engaged in for profit if the activity is profitable for two years of a consecutive seven-year period.
TIGTA emphasized that the IRS--and not the taxpayer--has the burden to rebut the presumption that an activity is not a for-profit business. Moreover, a taxpayer needs just the "objective" of making a profit. Many courts have found even a small chance of making a profit is sufficient. "The law allows taxpayers to justify a Schedule C loss by claiming a minimal profit," TIGTA cautioned.
Revenue Losses
TIGTA examined roughly 1.5 million returns filed from 2002 to 2005. All of these returns reported no profits, only losses. Based on their 2005 tax year income levels, 1.2 million taxpayers potentially avoided paying $2.8 billion in income taxes, TIGTA discovered. Most of that revenue loss could be attributed to roughly 300,000 higher income individuals whom TIGTA warned could evade $1.9 billion in taxes. More than 200,000 higher income individuals reported either no gross receipts or expenses two times higher than their gross receipts,
TIGTA uncovered.
Legislative Fix
The IRS agreed with TIGTA that Congress should tighten the hobby loss rules. In her reply to TIGTA, Kathy K. Petronchak, commissioner of the IRS Small Business/Self-Employed (SB/SE) Division, said the Service would work with the Treasury Department to propose legislation to create a "bright-line"
to determine if an activity is a business or a hobby. Petronchak added that the IRS would continue to educate taxpayers about the hobby loss rules.
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- IRS Cautions Taxpayers About Tax Scams
- Taxpayers Making Costly Mistakes When Claiming Federal Telephone Excise Tax Refund
Posted November 16, 2007.
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