However, in the five years she's been doing this, she's never made a profit. Nevertheless, every year she has deducted the expenses incurred by horse breeding. But unlike the previous four years, this year the IRS has red flagged her horse breeding business. Why?

 

Whether a hobby or a justifiable business expense, the Internal Revenue Service is scrutinizing reported cases where the profit motive of deducted expenses is not apparent. In fact, because it is commonly abused, the IRS seems intent on enforcing the hobby loss provisions of the tax code.

 

The regulations under §183 provide a nonexclusive list of factors the IRS considers when ascertaining a taxpayer's intent, one of which is the "elements of personal pleasure or recreation." In fact, horse breeding, yacht chartering, weekend farming and auto racing are a few of the "businesses" most flagged by the IRS.

 

While it isn't funny that taxpayers take advantage of the tax code with bogus claims, some cases scrutinized by the Tax Court deserve a laugh. Such as the couple that took lavish deep-sea fishing tournament trips for trophies and cash prizes at the tune of $100,000 to $1.5 million per trip. According to the Tax Court, the tournaments had an atmosphere resembling that of a college spring break and took place in some of the world's most beautiful locations.

 

Perhaps this would have been fine had the couple formed, say, a professional fishing corporation. But the couple's business was an S corporation that reported its principal business activity on its tax return as providing consultation on auto dealerships. Therefore, the Tax Court disagreed with the couple's claim that their fishing trips around the world were for their business.

 

With abusive claims such as this, it's no surprise the IRS is skeptical.

 

According to tax expert Michael Tucker, in the "facts-and-circumstances determination" of cases, judges of the tax courts tend to use an unofficial "smell test", asking themselves whether this is a viable business or simply somebody trying to scam the government.

 

"There have been cases where it's pretty obvious that the taxpayer never had any intention to enter into a real business," said Tucker in a recent CPA Report segment by SmartPros. "There was no intention to make a profit; it was just something they really liked to do, and they thought it might be a good idea to make it even better to take the losses as tax losses, rather than personal losses."

 

Tucker said accounting professionals simply need to sit down with the client and explain that a consistent loss over the years may make the expense a hobby rather than a business.

 

Once the IRS begins such an investigation, agents are not, necessarily, going to look just at the hobby loss. Most likely, explained Tucker, the agency uses the opportunity to probe into other factors of a claim, essentially turning the $2000 deduction into a massive, troublesome investigation.

 

Hobby losses are a question of facts and circumstances, explained Tucker. The facts and circumstances depend on the extent to which the taxpayers are or are not very serious about what they do.

 

Of course, if the taxpayer can prove profitibility over the years, the burden of proof is on the IRS, Tucker added.

 

For more information on this topic, sign up for The CPA Report's Individual Tax Update:  June segment A, from which this article is excerpted. This 1 credit course is available individually for $44.99, or included with a subscription to The CPA Report.