Hold Your Horses: How the IRS Determines Whether an Activity Is a Business or a Hobby

What Are the IRS Hobby Loss Rules?

Generally, taxpayers may deduct “ordinary and necessary” business expenses under Sections 162 and 212 of the Internal Revenue Code. Many taxpayers believe that they can deduct their expenses related to their passions, similar to how one may deduct expenses related to a business. However, Section 183 limits this deduction, stating that deductions may be allowed but only to the extent of gross income derived from the activity. In other words, the Internal Revenue Code prohibits taxpayers from claiming losses on their returns for activities that are not related to a trade or business.

When under examination by the IRS, an issue about whether the taxpayer is actually engaged in a for-profit activity may come up. When auditing a taxpayer who has claimed large deductions for an activity for which they have not generated any profit, the IRS needs to make a determination on one key question: Did the taxpayer have a profit motive? When there is a dispute between the IRS and a taxpayer regarding profit motive, the IRS will often argue that the taxpayer is actually engaged in a hobby, while the taxpayer will argue that they are operating a trade or business.

When these cases make it to Tax Court, the Court will consider the various factors outlined in Treasury Regulation § 1.183-2(b) and previous case law: (1) the manner in which the taxpayer carried on the activity; (2) the taxpayer’s or their advisor’s expertise; (3) the time and effort that the taxpayer has invested into the activity; (4) whether the taxpayer expected the assets used in connection with the activity will appreciate in value; (5) the taxpayer’s success in carrying on other similar or dissimilar activities; (6) the history of income or loss with respect to the activity; (7) the amount of profits that were earned from the activity; (8) the financial status of the taxpayers; and (9) whether the taxpayers enjoyed the activity for personal pleasure or recreation.

These cases are often not black-and-white, but rather turn on specific, relevant facts and circumstances. None of the factors listed above is dispositive. The Court will often look to each factor and weigh the factors in favor of the party with the most factors supporting its position. Taxpayers who are starting a business should be familiar with these factors in the event that the IRS disallows their losses under Section 183. This article will review a few interesting hobby loss cases so that taxpayers can familiarize themselves with the factors and how the Court analyzes them. You’ll notice that many hallmark hobby loss cases have one thing in common: horses.

Engdahl v. Commissioner (1979): When Horse Breeding Qualified as a Business

In Engdahl v. Commissioner, the Tax Court held that the taxpayers’ horse breeding operation was engaged in the activity for profit, allowing the taxpayers’ losses incurred in connection with the activity for each tax year at issue.

The taxpayers were a married couple who decided to breed American Saddlebred horses as a potential source of retirement income. The operations began in 1964. Later in 1967, the couple purchased a ranch and used most of the property for the horse breeding activity. At the ranch, they bred, trained, showed, and sold horses. They spent a considerable amount of time every week carrying out their horse operations. They also consulted numerous industry professionals, including horse breeders, trainers, veterinarians, and a tax professional. They incurred losses from the activity from 1964 through 1973. The IRS disallowed the losses for the years under examination.

The Court’s analysis of the nine profit motive factors resulted in a taxpayer victory. The Court reasoned that because the taxpayers kept detailed books and records, sought advice from other industry experts, invested substantial amounts of time and effort into the activity, and were within the typical 5- to 10-year start-up period for the horse breeding industry, the taxpayers were engaged in their operations for profit. This case is important because it outlines how taxpayers can prove a profit motive despite consistent losses from their operations.

Golanty v. Commissioner (1979): Why the Court Denied Business Loss Deductions

In Golanty v. Commissioner, the Tax Court held that the taxpayers did not have a genuine expectation of profit from their Arabian horse breeding ranches in California, despite keeping books and records, devoting significant time to the operations, and studying horse bloodlines. The operations generated losses from 1967 to 1973.

After analyzing the nine profit motive factors, the Court determined that the taxpayers did not have a profit motive in their horse operations. The Court focused on the fact that the operations historically generated losses and lacked profit potential given the amount of expenses incurred in the years at issue. The Court also focused on the taxpayers’ limited expertise regarding business ownership and their failure to consult with a professional regarding their business operations.

This case is significant because it demonstrates that spending a significant amount of time performing the operations is not enough to win the day in court. Taxpayers must demonstrate that their profit motive was genuine.

Skolnick v. Commissioner (2023): How Poor Records Undermined a Profit Motive

In Skolnick v. Commissioner, the Third Circuit affirmed the Tax Court’s finding that the taxpayers were not engaged in the activity for profit.

The taxpayers owned a Standardbred horse-breeding and racing operation. Before beginning their operation, the taxpayer had prior experience in the horse industry and had developed multiple business plans. They also employed staff and acquired a number of facilities where they maintained their horses. Despite the business plan and employees, the Third Circuit affirmed the Tax Court’s ruling that the taxpayers lacked a profit motive.

The Court reasoned that there was not a profit motive because the operations had lost more than $3.5 million during the years at issue, the books and records were inconsistent and incomplete, and there were substantial amounts of personal expenses paid for by the operations, including personal expenses related to a wedding and the building of a personal residence.

This case teaches a valuable lesson to taxpayers: commingling of business and personal expenses and inconsistent business records may defeat an argument in favor of the profit motive.

Schumacher v. Commissioner (2026): When Professional Tax Advice Helped Avoid Penalties

In Schumacher v. Commissioner, the Tax Court disallowed a couple’s losses related to their Quarter Horse breeding operations. The Court reasoned that the taxpayers had not established a profit motive because of the lack of business records, commingling of personal expenses, and the long history of losses with the operations. However, this case is unique because although the Court disallowed the losses except for the allowable deductions under Section 183(b), the Court waived accuracy-related penalties under Section 6662(a) because the taxpayers had relied on their longtime accountant’s advice on the deductibility of their expenses.

Because their reliance was reasonable given the accountant’s experience and expertise, the Court held that the accuracy-related penalties should be waived. This case demonstrates the importance of seeking professional advice, especially when beginning a business or new passion project.

Key Takeaways for Taxpayers Subject to IRS Hobby Loss Rules

These cases provide valuable lessons to taxpayers. Entrepreneurs should familiarize themselves with the nine profit motive factors to protect themselves in the event of IRS scrutiny. It is important to operate your business in a businesslike manner, maintain complete books and records, and keep personal and business funds separate. Further, it’s probably a good idea to seek advice from a tax professional, not only because the Tax Court would consider this a positive factor in a profit motive analysis but also because it may help avoid penalties in the event that the losses are disallowed.

Need Help Responding to IRS Hobby Loss Rules Challenges?

If the IRS has questioned your business deductions or claimed that your activity is a hobby rather than a business, experienced legal guidance can help evaluate your position and develop an effective response.

The Wilson Firm represents individuals and businesses in IRS examinations, tax disputes, and litigation involving business deductions, profit motive issues, and other federal tax controversies.

Contact The Wilson Firm to discuss your situation and explore your available options.