Many tax advisors are very cautious when it comes to claiming hobby losses – and some would argue overly so. This conservative view stems from the impression that the taxpayer usually loses when challenged by the IRS. While technically true that the odds aren’t in your favor of winning a challenge, the overall risk often works out in the taxpayer’s favor over the long run. Below we’ll look at why tax advisors should start from the assumption of taking the losses.
Always a Loser
Taxpayers usually lose hobby loss cases. Typically, the odds are around 3-to-1 in favor of the IRS. So, on the surface it seems like the smart bet is to assume you’ll lose, but there are reasons not to plan based on this fact. First, this statistic only represents cases that are decided by the court. Taxpayers are usually pretty stubborn and most cases are settled in much more favorable circumstances to the taxpayer.
Second, the “losers” are often winners in the long run.
Why Losers are Really Winners
When a taxpayer loses a hobby loss case, they usually face a deficiency and an accuracy penalty of 20 percent. The key issue here is how long before the loss is challenged?
Let’s take a pretend case as an example. Assume we have a taxpayer with tax losses of $60,000 per year, a 35 percent tax rate and they are audited for three years and lose. This results in a $63,000 deficiency ($60,000 x 35 percent x 3 years), plus an accuracy penalty of $12,600 (20 percent of the $63k). Had they not claimed the deduction, they would have paid the $63,000 in taxes anyway, so this isn’t really a loss; only the accuracy penalty is.
This doesn’t sound so great, does it? Why would someone take 3-to-1 odds in a scenario like this? Let’s think for a minute; what if the taxpayer had been taking the losses for 10 years? Those first seven years that were never audited allowed the taxpayer to take the deduction. In this case we have $21,000 x 7 years = $147,000 in deductions that the taxpayer would have missed if they played it conservatively. Next, our hypothetical taxpayer would still be up more than $134,000 over the long term ($147k, less the accuracy penalty).
This all of course assumes the taxpayer is sincere in his or her efforts to make money and is not playing the “audit lottery,” which is of course unethical.
Tax courts look to see if a taxpayer is genuinely and honestly engaged in the activity for profit. Objective honesty is the standard, and it doesn’t matter how slight the odds of turning a profit are. The IRS isn’t looking to judge the taxpayer’s business acumen, but their objective instead. You’ll need to truly be trying to make money with the activity or you’re doomed to lose.
In the end, if a taxpayer has an honest objective to make a profit through a hobby, claiming the losses is typically in their interest. While they are likely to lose if challenged, they are guaranteed to lose if they don’t take the losses themselves. Finally, even if they lose certain years under audit, they are likely to come out ahead in the long run. So, if you’re truly trying to make money in a venture that could be seen as a hobby, it might not pay to be conservative.