Do you know what the IRS is looking for?
Is there a secondary issue that the IRS raises (passive)?
When it comes to auditing hobby losses, especially in the horse industry, many people are not aware of what the IRS is looking for. This article serves the purpose of giving you some insight as to what the IRS wants as proof and how they go about preparing for their audit.
IRS examiners consider the following in their pre-audit analysis:
Are there activities with large expenses and little or no income?
Are losses offsetting other income on the returns?
Does the activity result in a large tax benefit to the taxpayer?
Does the history of the activity show that it is generating any profit in any years?
The IRS Agent uses a Section 183 guide as their manual, “Activities Not Engaged in For Profit.” The purpose of this guide is to assist in distinguishing between a business activity, a Non-Business “for profit” activity, an activity not engaged in for profit, and a personal activity.
The IRS looks at taxpayers who significantly reduce their taxable income by reporting losses from activities that may or may not be engaged in for profit. It is up to the IRS examiners to make a factual determination whether an activity is engaged in for profit.
Generally, the code allows individuals to deduct expenses which are incurred (1) in a trade or business or (2) for the production or collection of income, or for the management, conservation, or maintenance of property held for the product of income. For the expenses to be deducted under either code, the taxpayer must engage in or carry on activities to which the expenses relate with the objective of making a profit.
An activity that is presumed to be operated for profit requires an analysis of the facts and circumstances of each case. Deciding whether a taxpayer operates an activity with an actual and honest profit motive typically involves nine non-exclusive factors, which are as follows:
1. The manner in which the taxpayer carried on the activity
2. The expertise of the taxpayer or his or her advisers
3. The time and effort expended by the taxpayer in carrying on the activity
4. The expectation that the assets used in the activity may appreciate in value
5. The success of the taxpayer in carrying on other similar or dissimilar activities
6. The taxpayer’s history of income or loss with respect to the activity
7. The amount of occasional profits, if any, which are earned
8. The financial status of the taxpayer, and
9. Elements of personal pleasure or recreation
If the number of factors indicating the lack of profit exceeds the number indicating the presence of a profit objective (or vice versa) it is not conclusive. For example, if five factors say the activity is not for profit, but four are on the profit side, the activity still could be determined to be engaged as for profit.
The examiner will obtain as much information about the taxpayer’s business, learn as much as possible and prepare an interview outline that is tailored to the specific case. External electronic sources of information such as search engines & social media outlets are all sources of information that the agent will be looking at.
A business history will be developed and documented in the examiner’s work papers. Interviews should be used to obtain information needed to reach informed judgments about the scope of the examination and the resolution of the issues. These interviews can be used to obtain leads, develop information, and establish evidence along with information about the taxpayer’s financial history, business/activity operations, and accounting records. The examiner may need to use third party contacts in order to verify corroborating information from third parties examples.
One of the requirements of the examiner is that they must visit the business and actively tour the property such as a farm or where the horses are located. If the horses are kept at a third party location not owned by the taxpayer, the visitation may still occur. The examiner will also make sure that the gross receipts shown on the business records pertain to the business operation and not other income that can be reflected somewhere else on the tax return.
It is the responsibility of the taxpayer, to prove that he/she is in a trade or business. The examiner will check to determine if the taxpayer has their own business bank account, if most expenses are paid by check or credit card and if any personal expenses are going through the business account. It is very important that your books and records are adequately maintained. If they are not and do not appear as a business set of books, the IRS agent could use this as factor #1 of the nine factors.
The IRS agent is also looking for a business plan which would reflect the taxpayer’s financial economic forecast for the activity. The IRS agent is looking for a short range and long range forecast for the activity, allowing changes due to potential unforeseen and fortuitous circumstances.
This is just a taste of what the IRS agents are taught to look at to make their Sec. 183 determination. Now, however, you have alternative issues which the IRS has a better opportunity to win.
Under normal circumstances, you are able to offset business losses against other types of income (wages, interest, and dividends). However, losses from passive activitiesmay not be deducted against this type of income. Passive losses in excess of passive income are suspended and carried forward in the next succeeding year. Only when you sell your entire interest in the activity will you be allowed to take all of the suspended passive losses in a single year.
The best way to prove that you are not “passive” and materially participate in a trade or business is to prove any one of the following seven rules:
1. You participate more than 500 hours;
2. Your participation constitutes substantially all of the participation in the activity;
3. You participate for more than 100 hours and this participation is not less than the participation of any other individual;
4. The activity is a “significant participation activity” and your participation in all such activities exceeds 500 hours;
5. You materially participated in the activity for any five years of the 10 years that preceded the year in question;
6. The activity is a “personal service activity” and you materially participated in the activity for any three years preceding the tax year in question; or
7. You satisfy a facts and circumstances test that requires you to show that you participated on a regular, continuous, and substantial basis.
Methods of Proof:
To meet the record-keeping requirements, the taxpayer must establish his material participation by reasonable means. These may include:
An identification of the services provided; AND,
The approximate number of hours spent, based on appointment books, calendars or narrative summaries.
Contemporaneous daily records are not required if the taxpayer’s participation can be reasonably established. If records provided are not reasonable, i.e., there is a credibility issue, they may request contemporaneous records.
Indicators that the IRS Looks at:
Indicators that the taxpayer did not materially participate:
The taxpayer was not compensated for services.
The taxpayer’s residence is hundreds of miles from the activity.
The taxpayer has a W-2 wage job requiring 40+ hours a week for which he or she receives significant compensation.
The taxpayer has numerous other investments, rentals, business activities, or hobbies that absorb significant amounts of time.
There is paid on-site management/foremen/supervisor and/or employees who provide day-to-day oversight and care of the operations.
The taxpayer is elderly or has health issues.
The majority of the hours claimed are for work that does not materially impact his time or business.
Key Points the IRS Reviews:
Does the taxpayer work on a regular basis in the operations of the business activity?
Has the entity been grouped by the taxpayer with another related entity as a single activity?
Is the entity a significant participant activity (SPA)? If so, are there other SPAs (passive businesses) with which it can be grouped, and does the sum of all SPA hours exceed 500 hours for the tax year?
Is the time claimed plausible in terms of the taxpayer’s other commitments or from a common sense standpoint?
The IRS will try to treat some of your time performed as investor hours such as:
Studying or reviewing financial statements or reports
Preparing or compiling summaries or analysis for individuals own use
Monitoring financing or operations in a more managerial capacity
Reading articles and trade publications
Whether, and how regularly, the taxpayer is present at the places or place where the principal operations of the activity are conducted.
The above list is not all-inclusive. Other activities could also be investor-type activities such as organizing records, preparing taxes, and paying bills.
In summary, the IRS is doing their best to win on either issue. Preparation for the possibility of an IRS Audit, such as record keeping for all of your activities, will give you a better chance of winning these issues.
For more information contact our offices:
Frank Palino - email@example.com
Jim Benkoil - firstname.lastname@example.org
Any tax advice expressed was not intended or written to be used, and cannot be used, by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer. If this advice was written to support the promotion or marketing of partnership or other entity, investment plan, or arrangement to any taxpayer then the advice was written to support the promotion or marketing of the matters addressed by the written advice and the taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax adviser.