Preparing for an IRS Challenge Under the Hobby Loss Rules

By Kenneth H. Bridges, CPA, PFS     July 2015

In order to be deductible as a business expense, an expense must be ordinary and necessary and be incurred in an activity engaged in for profit.  Under the “hobby loss” rules, there is a rebuttable presumption that you have engaged in an activity for profit so long as the activity is profitable at least 3 out of 5 years (2 out of 7 in the case of horse related activities).  To the extent you have tax losses from an activity that many might view as a hobby (e.g. horse breeding, showing and racing), you should be prepared to demonstrate to the IRS that you engaged in such for the purpose of earning a profit.  A recent Tax Court case (Metz) provides a template for how to do this.

The Metzes lost millions of dollars through their Arabian horse farm.  The IRS challenged the tax deductibility of the losses on the basis that it was a hobby.  The Tax Court, however, permitted the losses because the Metzes were able to show that they acted in a business-like manner, kept good records, worked full time in the business, had written business plans, engaged professional advisors,  developed expertise in Arabian horses, engaged in extensive advertising and promotion, and relocated the business twice in an effort to make it profitable.

Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.

This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice.  The article provides only a very general summary of complex rules.  For advice on how these rules may apply to your specific situation, contact a professional tax advisor.