Caleb currently works full time in Harpers Hideaways. He used to work as a full time manager in Ski n Sports. In addition to this, Caleb also worked as a ski instructor only for the winters with the Wolf Creek. Caleb’s father died in 2013, he became very depressed and planned starting a business of guide and retreat in the inherited property of them mother in Pagosa spring. Caleb had prior experience so he worked in a very involved and enthusiastic manner in the new business, Harper Hideaways. Caleb engaged advertising agencies for promoting the business and in addition, they carried out online campaigns as well. In order to run the business competently Caleb invested in developing a slick website so that orders can be booked online. In addition to this he also purchased for the business the rafts, kayaks, tents etc. This all equipments were very expensive so in spite of having a regular flow of customer Caleb lost money in the business. The business in which Caleb is engaged is also his hobby so there is confusion that if the activities are treated as hobby then the loss will not be allowed as deduction.
In this case, the issue is to ascertain whether the activity the carried on by Caleb is business or hobby. In addition, it is also required to be determined whether the loss from Harper Hideaway is deductible.
- Internal Revenue Code Section 183
- Internal Revenue Code Section 162
- Internal Revenue Code Section 212
- Internal Revenue code section 162
- Treasury Regulations 1.183-1
- Treasury Regulations 1.183-2
- Revenue Ruling 55-258
- Revenue Ruling 75-14
- Revenue Ruling 77-230
- Revenue Ruling 2004-32
The section 162 provides that a deduction can be claimed for all the ordinary and necessary activity carried on by the business. The amount of deduction that can be claimed as deduction on depends on the provisions of section 183. The Section 183 “Activities not engaged in for profit” of the Internal Revenue Code, states that if an individual or corporation is engaged in an activity not for making profit then in such cases no expenses or losses attributable to the activity is allowed as deduction except that is provided in the section (Jones et al., 2014). The section 183 (b) provides that deduction will be limited to the amount of income generated by the business activity and the maximum limit of additional deduction allowed is 2% of annual gross income. Therefore, in order to determine the amount of allowable deduction it is important to ascertain whether the activity is business or hobby (Hoffman & Smith, 2014).
Nine factors are listed under Regulations 1.183-2 (b) to ascertain whether the taxpayer is engaged in business or hobby. These nine factors are discussed below:
The manner in which the activity is conducted by the taxpayer.
It is firstly important to ascertain whether the taxpayer in a businesslike manner conducts the activities. This can be established if the taxpayer maintains a separate bank account for the activity, maintains separate books of accounts and acting in the same manner as a profitable entity (Palan, 2016). In the given case, Caleb maintained the accounts in QuickBooks that helped him to track the expenses and income. Therefore, this condition is satisfied.
The Expertise or Knowledge of the Taxpayer
It is important that the operator of the business should have extensive knowledge about the activities of the business. It is an important factor for determining the business. Caleb was highly experienced and had deep knowledge of the business. Therefore, Caleb also fulfills this condition of having experience.
The Time and Effort of the Taxpayer
TIn order to determine whether the activity is business or hobby it is important to determine the time and effort that the taxpayer is devoting in the activity. If the taxpayer is dedicating more time and effort in the activity then it can be said that the taxpayer is engaged in the business with the intention of making profit (Strine, 2015). In this case, Caleb has sacrificed full time job for the business and is always engaged in the different activity of the business. It can be said that as the Caleb is putting more time and effort therefore it can be said that he is engaged in business activity with the intention of making profit.
It is Expected that the Assets will Increase Value
These factors considered that though there may be initial loss in the activity but the taxpayer can engage in the activity with the intention of making profit with the increase in value of the assets. In such cases, the activity will be considered as business activity. Caleb’s venture Harpers highway has made loss initially but Caleb is planning to purchase more equipment and renovate the property. Therefore, it can be said that Caleb believes the assets will increase value so it can be said as business activity.
The Success in other Activities Undertaken by the Taxpayer
In this factor, it is important to consider whether the taxpayer has the ability to convert the loss making activity into a profitable activity. It is ascertained by comparing the performance of the taxpayer in the related activities (Gale & Brown, 2013). Caleb has performed full time and part-time jobs successfully. Therefore, it can be said that Caleb has the ability to convert it into profitable business so it is a business.
The Historical Income and Loss from the Activity
It is not necessarily true that if any activity leads to profit then it is engaged for profitable purpose and if it leads to loss then the activity is not engaged in the profitable purpose. It is therefore important to consider this factor. There is no historical profit and loss as the business has just started initially and in the current year, it has suffered loss.
The Occasional Profit and Losses
According to the section 183-2(b)(7) “ The amount of profit in relation to the amount of losses incurred, and in relation to the amount of the taxpayers investment and the value of the assets used in the activity, may provide useful criteria in determining the taxpayers intent.” In accordance with the section, 183(d) if an activity has gross income in the three or four years in last 5 years then in such cases, it will be assumed that the taxpayer is engaged in the business for making profit (Meese & Oman, 2014). This rule is not currently applicable in this case.
The Financial Status of the Taxpayer
In accordance with this factor, the income from other sources will help to ascertain whether the taxpayer is engaged in the activity as hobby or business. Caleb has no other sources of income and is currently involved only in this activity so it is a business.
The Activity Engaged for Personal Recreation
In this regulation, it is indicated that the personal motive means that the activity is not engaged as a business. The motive is an important factor if the taxpayer engages in an activity for the purpose of making profit then it is a business activity. In this case, Caleb has the motive of making Harpers Highway profitable as he has left fulltime work and is currently only working in this venture.
It should be noted that not the individual factors but the overall factors are considered to determine the nature of the activity.
Based on the analysis above and facts of the case it can be concluded that the Caleb is engaged in business activity and not hobby therefore the loss will be allowed as deduction without any limitations. The reason for the conclusion is that as per the requirement of section 183 Caleb has sufficient knowledge of the activity and has engaged experts to conduct various activities in a professional manner. The Caleb does not have any other sources of income and is completely engaged in the activity. The most important regulation is also satisfied Caleb maintains the accounts of the business in accounting software quick. Therefore based on this facts and the nine factors under section 183 it can be concluded that the Caleb is engaged in business activity.
Gale, W. G., & Brown, S. (2013). Small business, innovation, and tax policy: A review. Innovation, and Tax Policy: A Review (April 8, 2013).
Hoffman, W. H., & Smith, J. E. (2014). South-Western Federal Taxation 2015: Individual Income Taxes. Cengage Learning.
Jones, C. R., Usrey, S. C., & Webb, T. Z. (2014). Taxation of Gambling in the United States: Comparing the Current System with Two Alternatives. The ATA Journal of Legal Tax Research, 12(2), 34-53.
Meese, A. J., & Oman, N. B. (2014, May). Hobby Lobby, Corporate Law, and the Theory of the Firm: Why For-Profit Corporations Are RFRA Persons. InHarvard Law Review Forum (Vol. 127, p. 273).
Palan, R. (2016). 9 Corporate power in a global economy. Susan Strange and the Future of Global Political Economy: Power, Control and Transformation, 152.
Strine Jr, L. E. (2015). Job Is Not a Hobby: The Judicial Revival of Corporate Paternalism and Its Problematic Implications, A. J. Corp. L., 41, 71.