Taxpayers Who Deduct Potential Hobby Losses to Offset Other Income
The Treasury Inspector General for Tax Administration (TIGTA) today publicly released its audit report of the Internal Revenue Service’s (IRS) methods of addressing taxpayers who take business tax deductions for activities not engaged in for profit.
TIGTA found that the IRS can improve its methods for identifying high-income taxpayers who may be offsetting their income with “hobby losses” from unprofitable business activity.
The tax code allows taxpayers to deduct all ordinary and necessary expenses paid or incurred in carrying on a trade or business.
However, in the “hobby loss” provision in the tax code, the IRS generally disallows business tax deductions for activities not engaged in for profit.
TIGTA found that the IRS does not maximize the use of all relevant and available taxpayer information to identify hobby losses, and when returns containing potential hobby losses are selected for audit, the examiners do not always address the hobby loss issues.
A September 2007 TIGTA report found that approximately 1.2 million taxpayers in Tax Year 2005 may have used hobby losses to reduce their taxable incomes to potentially avoid paying $2.8 billion in taxes. Identifying and auditing additional individual returns that improperly deduct hobby losses could help to reduce noncompliance in this area.
This audit was initiated as a follow-up to that previous 2007 report to determine whether the IRS was maximizing opportunities to identify the most significant Schedule C, Profit or Loss From Business, noncompliance.
The overall objective of this review was to determine whether the IRS is taking sufficient action to minimize improper Schedule C losses claimed by taxpayers.
TIGTA’s evaluation of IRS data from Processing Years 2011 through 2014 identified 9,699 individual returns from Tax Year 2013 that claimed a Schedule C loss of at least $20,000, gross receipts of $20,000 or less, and reported wages of at least $100,000. The taxpayers also reported losses in four consecutive years (Tax Years 2010 to 2013).
TIGTA’s review of a statistically valid sample of 100 returns determined that 88 returns (88 percent) showed an indication that the Schedule C businesses were not engaged in for profit.
TIGTA estimates that 7,511 returns in the total sample population of taxpayers may have inappropriately used hobby loss expenses to reduce taxes by as much as $70.9 million for Tax Year 2013.
“Taxpayers with significant amounts of income from other sources may attempt to reduce their tax liability by including losses from activities not engaged in for profit,” said J. Russell George, the Treasury Inspector General for Tax Administration. “The IRS needs to effectively identify these taxpayers in order to deter future non-compliance,” he added.
TIGTA recommended that the IRS:
1) make use of its research capabilities to identify high-income individual returns with multiyear Schedule C losses and other factors that indicate the taxpayer may not have a profit or capital gain motive for the activity, and
2) emphasize the importance of the required checks of filed tax returns in the preliminary determination of whether to pursue a hobby loss issue and provide tools to assist examiners in documenting their conclusion.
In response to the report, IRS management agreed with TIGTA’s recommendations and plans to take corrective actions.
