Individuals often contend that their hobbies have a profit motive in order to obtain a more favorable tax outcome. But when such disputes reach Tax Court, the IRS often prevails. With hobby expenses generally non-deductible under the Tax Cuts and Jobs Act, the stakes have become even higher in recent years. The authors take a close look at one recent case and review the relevant regulatory factors; their analysis indicates a taxpayer’s chances of prevailing in court and suggests effective planning, documentation, and legal strategies.
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The IRS frequently disputes taxpayers’ claims that hobby activities are profit-motivated. Although these disputes have always been routine, recent developments are likely to make them even more frequent. The number of taxpayers reporting that they work a “side hustle” for additional income has risen significantly in recent years. In 2022, for example, the number of workers reporting a secondary source of income rose to 44% (https://cnb.cx/3pmVili). At the same time, the tax stakes have also increased. Under the Tax Cuts and Jobs Act of 2017 (TCJA), hobby expenses are no longer deductible as miscellaneous itemized deductions. This creates a whipsaw effect for unwary taxpayers: hobby activity income, if any, continues to be taxable, but related hobby expenses are generally nondeductible. Some expenses (e.g., personal residence mortgage interest and property tax related to a home office) may still be deductible under other provisions.
Prior research on hobby litigation has revealed that the Tax Court decides such disputes in the IRS’s favor more than 75% of the time. More recent Tax Court cases have demonstrated that this trend continues. Using one of those recent cases (Whatley v. Comm’r, T.C. Memo 2021-11) as a platform for discussion, this article reviews the relevant regulatory factors and how the Tax Court applies them. It also analyzes a taxpayer’s chances of prevailing in Tax Court and suggests effective planning, documentation, and defense strategies for improving those chances.
Deductibility of Hobby Expenses
As a general rule, taxpayers may only deduct expenses associated with profit-motivated activities [IRC section 183(a)]. Thus, taxpayers generally may not deduct expenses associated with activities not engaged in primarily for profit [i.e., personal expenses; see IRC section 262(a)]. There are, of course, a host of familiar exceptions to this general rule (e.g., qualified residence interest, property taxes on a personal residence, medical expenses, among others). Those few deductible personal expenses, however, are mostly itemized deductions subject to substantial limitations, such as income floors, ceilings, and phase-outs. [See, e.g., IRC section 67 (miscellaneous itemized deductions only allowable to the extent they exceed 2% of AGI); section 165(c) (personal casualty losses only allowable to the extent they exceed 7.5% of AGI); section 213 (medical expenses only allowable to the extent they exceed 10% of AGI); and section 68(a) (reducing allowable itemized deductions of certain “high income” taxpayers). The alternative minimum tax has further rules reducing or eliminating a taxpayer’s itemized deductions under IRC sections 55–59]. Because of this disallowance or substantial limitation of personal deductions, taxpayers sometimes expend a great deal of energy trying to characterize personal activities as profit-motivated.
This manifests itself most often when taxpayers engage in activities that have—at least for themselves—significant elements of pleasure or enjoyment. Gambling, horse breeding, auto racing, and sport fishing are only a few common examples. Such activities usually produce little income, but taxpayers incur significant expenses to pursue them. Notwithstanding the losses these activities produce, taxpayers often take the position that they engage in an activity with the intent to earn a profit, typically arguing the activity is a business. (Not all profit-motivated activities are businesses. So, conceptually, the question of whether the taxpayer engaged in a particular activity for profit and, if so, whether that activity is a business, are two separate issues. Nonetheless, courts often collapse the two questions into one.) The taxpayer’s motivation is twofold. First, the taxpayer, if successful, can deduct otherwise nondeductible personal expenses. Second, the taxpayer can deduct excess hobby expenses (purported “business losses”) against other income, such as salary or income from another business or professional activity.
To be able to deduct expenses related to an activity, a taxpayer must demonstrate that profit was their primary motivation for engaging in the activity. The taxpayer’s primary motivation is a question of fact. A court will infer the taxpayer’s subjective intent from the objective facts and circumstances. The applicable guidance (Treasury Regulations section 1.183) provides nine specific factors that the Tax Court should consider when determining whether a taxpayer is primarily motivated by profit with respect to any activity. The factors are non-exclusive, are not all necessarily applicable in any particular case, and the trier of fact (i.e., the court) assigns their relative importance to each case. These factors are:
- The manner in which the taxpayer carries on the activity
- The expertise of the taxpayer or their advisors
- The time and effort expended by the taxpayer in carrying on the activity
- Expectation that assets used in the activity may appreciate in value
- The success of the taxpayer in carrying on other similar or dissimilar activities
- The taxpayer’s history of income or losses with respect to the activity
- The amount of occasional profits, if any, which are earned
- The financial status of the taxpayer
- Elements of personal pleasure or recreation.
Whatley v. Comm’r
In 2021, the Tax Court concluded in Stephen Whatley, et ux. v. Comm’r (TC Memo 2021-11) that a taxpayer’s purported cattle farm activity was not profit-motivated for numerous reasons, one of which was that the farm lacked any cattle. Unlike the Crile decision discussed in the authors’ earlier article [Cook, J. and S. Webber, “40 Years of Losses, but Still Motivated to Profit,” The CPA Journal, April 2016, pp. 34–43], the Tax Court’s Whatley decision struck us as quite reasonable and appropriate.
The taxpayer in the case, Stephen Whatley, was a veteran bank employee and the owner of his own bank, Southern States Bank. He was a hard worker; even in his seventies, he worked 70 hours per week for Southern States and regularly traveled for business. Whatley’s banking business yielded substantial income (AGI between $320,000 and $1,469,567) during the tax years in question.
In 2003, around the time Whatley founded Southern States, he purchased 156 acres of heavily forested land that had once been used as a timber and cattle farm but was not actively being farmed. At his CPA’s suggestion, Whatley formed a limited liability company, Sheepdog Farms, to operate this purported farm. Whatley never transferred the 2003 parcel to Sheepdog Farms. In 2004, Whatley purchased an additional 26 acres. The 2004 parcel was adjacent to the 2003 parcel and included a home, a barn, and a caretaker’s house. Whatley transferred the 2004 Parcel to Sheepdog Farms.
Despite his 70-hour-per-week schedule at Southern States, Whatley testified that he worked approximately 700 hours per year for Sheepdog Farms, primarily on the farm’s timber operation; however, no timber harvesting had taken place on either the 2003 or 2004 parcel since before Whatley purchased them. Indeed, the 2003 parcel was subject to a Department of Agriculture Conservation Reserve Program that prohibited timber harvesting until at least 2021.
Notwithstanding the purported timber operations, Sheepdog Farms’ income tax returns described its principal product as cattle. But there were no cattle present on either parcel until 2008. It was not until shortly after the IRS notified him that it would audit Sheepdog Farms’ returns that Whatley decided that the cattle farm should have cattle on it.
Unsurprisingly, the cattle-less cattle farm and the timber operation with unharvestable timber produced regular losses, totaling over $1.5 million in a 10-year period.
As the Tax Court wryly noted, “something about this [the recurring significant losses] snagged the Commissioner’s attention,” and the IRS began an audit of Sheepdog Farms’ returns. Ultimately, the IRS disallowed Sheepdog Farms’ deductions, asserting that the activity was not engaged in for profit. Whatley petitioned the Tax Court, which decided the case in favor of the government.
Tax Court’s Application of the Nine-Factor Test in Whatley
The following is a brief summary of the court’s application of each regulatory factor.
The manner in which the taxpayer carries on the activity. Whatley kept minimal records for Sheepdog Farms. He did not maintain a separate checking account. He did not create a business plan, and only created a forest-management plan after the IRS notified him of its impending audit several years after Sheepdog Farms was formed. In any event, the court characterized what little records Whatley had as “not exactly accurate.” The court also seemed to doubt whether the records were contemporaneous, hinting that it suspected they had been created after the fact for purposes of the IRS’s audit. Crucially, the lack of records prevented Whatley from analyzing the farm’s income and expenses and tracking its business performance. Whatley was unable to provide convincing evidence that he adjusted operations to react to changes in the business environment. Sheepdog Farms incurred substantial losses for the years under audit—indeed, for all the years of its existence—with no evidence of effort by Whatley to improve profitability. The court identified two additional concerns regarding the manner in which Whatley conducted the activity. First, Whatley never transferred title to the 2003 parcel to Sheepdog Farms. Of course, this was not strictly necessary from either a legal or tax perspective (e.g., the property could have been leased). Nonetheless, Whatley’s failure to do so troubled the court. The court was particularly bothered by the fact that “Sheepdog Farms claimed expenses related to land that it didn’t own.” Second, Whatley depreciated the two homes on the 2004 Parcel as business use property but simultaneously deducted mortgage interest on those same two homes as qualified personal residence interest (creating an inconsistency of treatment, i.e., characterizing a home as a personal residence for qualified interest deduction, while simultaneously depreciating it as a business-use asset). This mingling of Whatley’s business and personal properties and activities did little to convince the court that Whatley treated Sheepdog Farms as a business venture.
The expertise of the taxpayer or the advisors. Whatley had no expertise in either forestry or cattle ranching, and his testimony that he consulted with cattle and timber experts failed to impress the court. The court concluded that Whatley failed to act upon the experts’ advice, if any, to improve the business’s profitability.
The time and effort expended by the taxpayer in carrying on the activity. The court seemed unconvinced by Whatley’s testimony regarding the time and effort he expended in the business. In light of his testimony that he worked 70 hours per week at Southern States, the court was skeptical of his claim that he spent nearly 14 additional hours per week working for Sheepdog Farms.
Expectation that assets used in activity may appreciate in value. Whatley testified that he expected that the timber would appreciate in value. The court was skeptical of Whatley’s supposed expectation as a factual matter. More importantly, the court concluded that even if the timber appreciated significantly, it would never do so sufficiently to offset Sheepdog Farms’ significant and regularly recurring losses.
The success of the taxpayer in carrying on other similar or dissimilar activities. Whatley had never carried out farm activities before owning Sheepdog Farms, but he had founded and still successfully operated his banking business, Southern States. The court’s opinion was silent as to whether it considered this factor, however, or what its conclusion was if it did.
The taxpayer’s history of income or losses with respect to the activity. Although the audit period was 2004–2008, evidence of Sheepdog Farms’ operations was presented for 2004–2014; each year resulted in a loss. The court said these losses were “so sustained and so large that we cannot find them to be transitory or unexpected.”
Reporting frequent losses does not necessarily doom a taxpayer’s chances of obtaining a business designation. Courts, particularly the Tax Court, are remarkably tolerant of losses.
The amount of occasional profits, if any, which are earned. This factor did not apply in this case because Sheep-dog Farms never posted a profit at any time during its existence.
The financial status of the taxpayer. Whatley had significant income from his banking career and received a significant tax benefit by offsetting Sheepdog Farms’ losses against his banking income. The court summarized its consideration as follows:
[Sheepdog Farms] had consistent and substantial losses which totaled over $1.5 million from 2004-14. Even if [Whatley] later cut and sold the timber, he had no chance of turning a profit; but Sheepdog Farms’ expense, if allowed, would substantially offset his income from other sources. That deduction is just what section 183 prevents.
Elements of personal pleasure or recreation. Whatley did not hire others to help on his farm—not surprisingly, because with neither cattle nor harvestable timber, there was little to be done. The court inferred that whatever time Whatley did spend on the farm was as “a retreat from his grueling and time-consuming banking business.”
In light of the foregoing analysis, the court ruled in the IRS’s favor, concluding that none of the nine factors supported Whatley’s contention that his Sheepdog Farms activity was profit motivated.
Comparing Whatley with Other Farm Cases
As previously mentioned, the Tax Court’s decision in Whatley is not surprising. Reporting frequent losses does not necessarily doom a taxpayer’s chances of obtaining a business designation. Courts, particularly the Tax Court, are remarkably tolerant of losses. Crile (TC Memo 2014-202) is undoubtedly an extreme example. The activity in Crile produced only one profitable year in over four decades of losses, but the Tax Court nonetheless concluded that the taxpayer was motivated by profit. This is especially true in the case of farming activities [see Faulconer v. Comm’r, 748 F.2d 890, 900, n.12 (4th Cir. 1984); Riker v. Comm’r, 6 B.T.A. 890, 893 (1927)]. But with literally none of the regulatory factors satisfied, not even a (purported) farmer can reasonably expect to win. The authors’ research (discussed in more detail below) indicates that the single most important thing a taxpayer can do to increase their chances of prevailing against an IRS challenge is to treat their activity like a business. If taxpayers do not treat the activity like a business, they can hardly expect the IRS or a court to do so. Business plans, market studies, advertising, separate books and bank accounts, periodic financial reviews, and modifications to business operations intended to improve profitability (or even just to reduce losses)—these and similar efforts can impress courts and significantly improve a taxpayer’s chances of success.
Like in Whatley, taxpayers who fail to treat a contested activity as a business generally lose. For example, in Gardner v. Comm’r (T.C. Memo 2014-148), the taxpayer was in the insurance business but had many side ventures, including a cattle operation that produced large losses (three times the fair market value of the cattle). No reasonable expectation existed that the cattle would appreciate in value sufficient to offset losses. Gardner also failed to maintain adequate records. The Tax Court found that the cattle operation was not profit motivated. Similarly, in Williams v. Comm’r (T.C. Memo 2018-48), the court held a ranching activity to be a hobby after Williams operated the ranch for five years and generated a total loss of $1.7 million. Williams was a successful writer and devoted fewer than 10 hours per week to the ranch. The court was particularly concerned that Williams failed to create a business plan, conducted no financial reviews, and did not attempt to improve profitability.
In contrast, taxpayers who treat their activity as a business generally win. For example, the taxpayers in Stromatt (Freddie Stromatt, et ux. v. Comm’r, TC Summary Opinion 2011-42) survived an IRS challenge despite recurring losses. Mr. and Mrs. Stromatt successfully showed that they operated in a businesslike manner by maintaining a separate ledger of the cattle activities and keeping receipts. Their record-keeping was largely informal, but not inappropriate for a small farming operation. The Stromatts relied upon the advice and expertise of Mrs. Stromatt’s father, an experienced farmer. The court was willing to accept the Stromatts’ losses from farming as “brief and not atypical.” Similarly, the taxpayer in Welch v Comm’r (T.C. Memo 2017-229) also prevailed, despite years of large losses. Although no formal written business plan existed, Welch was able to prove that he kept books and records, employed experts, and followed their advice.
Pitfalls to Avoid and Recommendations for Success
The Whatley case is extreme in that the taxpayer was unable to persuade the court that any aspect of his farm activity supported a profit motivation. Nonetheless, it poses an important question: How many taxpayer-favorable factors would have warranted a business designation? In the authors’ empirical research on Tax Court hobby loss cases under IRC section 183, we found that a taxpayer need not have a majority of factors (i.e., five or more) in their favor to win a case. The Exhibit shows how the probability for a taxpayer win in Tax Court increases with the number of factors found in the taxpayer’s favor. A statistical analysis suggests that had Whatley persuaded the court to find any three factors in his favor, his probability of success would have been better than even at slightly over 60%; a fourth would have raised his chance of winning to just under 90%.
Exhibit
Taxpayers’ Chance of Success Increases as the Number of Favorable Factors Increases
The authors’ analyses also indicate that even if a taxpayer is awarded only a single factor, the probability of having an activity designated as a business is over 95% if the court can be convinced that the activity is carried out in a businesslike manner. Unfortunately, taxpayers in Tax Court are able to do this only about 20% of the time.
As mentioned above, the Tax Court is quite tolerant of losses. Consequently, the taxpayer in Whatley faced a low bar for success. His failure to conduct his activity in a businesslike manner likely contributed significantly to his Tax Court loss. Whatley’s actions (or omissions) with regard to Sheepdog Farms highlight some pitfalls for other taxpayers to avoid: using personal bank accounts to pay expenses for a purported business; failing to keep records of revenues and expenses; lacking a business plan; not attempting to improve profitability; failing to seek or follow experts’ advice; and deducting personal expenses related to purported business properties.
The things that are likely to carry the day for the taxpayer in an IRC section 183 dispute with the IRS are not exceptionally difficult, nor are they particularly expensive.
Lessons Learned
Tax professionals are familiar with the general rule that substance almost always trumps form. But this is one area of tax law where form really matters. And form is very much in the taxpayer’s control. The things that are likely to carry the day for the taxpayer in an IRC section 183 dispute with the IRS are not exceptionally difficult, nor are they particularly expensive.
In an IRS audit, the importance to the taxpayer of showing that an income-producing activity is conducted in a businesslike manner cannot be overstated. It is therefore crucial for CPAs and other financial advisors to regularly communicate with clients and encourage them to share information about income-producing hobbies or nascent businesses. Regular activity losses will elicit IRS scrutiny. Timely and effective tax advice, including careful planning to satisfy the nine-factor test, can ensure that a taxpayer is prepared to produce evidence of proper recordkeeping and business-appropriate operations, should an IRS challenge occur.