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The thin line between business expenses and hobby losses

Last week we discussed the fact that sometimes business expenses are characterized as hobby losses by the IRS. The line between business expenses and hobby losses is sometimes thin, especially in the context of new businesses.

We also discussed a recent tax court case that involved an author who claimed $19,140 in businesses losses associated with his worldwide trip that was taken to gather material for a book. The IRS disallowed the expenses and stated that the would-be author really had hobby losses, not business expenses.

Taxpayers are entitled to deduct all of the "ordinary and necessary business expenses paid or incurred during the taxable year in carrying on a trade or

business." In the context of business expenses, one of the crucial questions that arises is whether a taxpayer is engaged in a trade or business. This is determined by a three-part test which consists of the following questions:

  1. Whether the taxpayer claiming business losses undertook the activity intending to earn a profit.
  2. Whether the taxpayer is regularly and actively involved in the activity.
  3. Whether the taxpayer's activity has actually commenced.

The problem that the taxpayer in the tax court case ran into is that he did not present evidence of "continuous or repeated activity as an author." The tax court case was decided last week, nearly five years after the taxpayer's trip, and the taxpayer failed to author any books at all during this time.

And although other employment doesn't preclude the deduction of expenses associated with being an author, the fact that the taxpayer was a full-time employee and failed to write any books caused the court to determine that the taxpayer did not show "some intent or effect on his part to engage in and continue in the writing field with substantial regularity and with the purpose of producing income and a livelihood."

A related problem is that the taxpayer did not have the necessary receipts or documentation to support his deductions.

The taxpayer was able to escape paying an accuracy-related penalty however because his decision to deduct the trip expenses was made on the advice of an experienced tax professional.

Source: T.C. Memo. 2012-4, "Michael S. Oros v. Commissioner of Internal Revenue," Docket No. 19400-009, Jan. 5, 2012

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