2017 CHANGE IN LAW RAISES STAKES IN § 183 CASES
August 2022 American Horse Council Tax Bulletin
The Tax Cuts and Jobs Act of 2017 (“TCJA”) changed the law concerning the consequences of losing a Section 183 (“hobby loss”) challenge by the IRS.
Under the prior law, if a horse-owning taxpayer lost a §183 “Hobby Loss” challenge by the government, the horse owner could at least take deductions up to the amount of income that the activity earned. For example, if an activity had a $100,000 loss, after taking into account $50,000 in income earned during that year, that year was challenged as a hobby by the IRS and the IRS prevailed, the activity owner could at least take $50,000 in deductions, i.e., up to the amount of income earned.
Thus, under prior law, the horseman/horsewoman, even if they lost the battle to prove that their activity was a profit-motivated one, they could still deduct their expenses up to the extent of income in the activity, taking expense deductions first, but even including “basis-adjusting” deductions (e.g., depreciation) if there is income left to offset.
However, under the TCJA, if a taxpayer loses a § 183 Hobby Loss case, then all the income earned must be reported and tax paid on it, but none of the deductions may be taken. Such a result is harsh. Yet it is now the law. The lesson for horse business owners is two-fold:
Under the prior law, if a horse-owning taxpayer lost a §183 “Hobby Loss” challenge by the government, the horse owner could at least take deductions up to the amount of income that the activity earned. For example, if an activity had a $100,000 loss, after taking into account $50,000 in income earned during that year, that year was challenged as a hobby by the IRS and the IRS prevailed, the activity owner could at least take $50,000 in deductions, i.e., up to the amount of income earned.
Thus, under prior law, the horseman/horsewoman, even if they lost the battle to prove that their activity was a profit-motivated one, they could still deduct their expenses up to the extent of income in the activity, taking expense deductions first, but even including “basis-adjusting” deductions (e.g., depreciation) if there is income left to offset.
However, under the TCJA, if a taxpayer loses a § 183 Hobby Loss case, then all the income earned must be reported and tax paid on it, but none of the deductions may be taken. Such a result is harsh. Yet it is now the law. The lesson for horse business owners is two-fold:
- Prepare to win a § 183 challenge. Make sure that you have accurate books and records. Compare your operation to the Nine factor test found in Treasury Regulation 1.183-2(b)(1)-(9). You might want to consult with your tax professional on your state of readiness to repel a government challenge.
- If your activity is challenged by the government on the basis that it is not operated primarily for profit, FIGHT HARD. The real test is your subjective motivation, so you really do know the correct answer. But, you have to prove your motivation, and the government will not simply take your word for it. It is worth an all-out fight to prove your profit motive, because the penalties for losing that fight are now much more costly than before.