Tax Court Ruling on Activity Qualified As Business, Not Hobby
In TC Memo 2016-71, the Tax Court found that a taxpayer’s hair-braiding activity qualified as a business, where the taxpayer had a genuine, if optimistic, intent to earn a profit. The court allowed the taxpayer to deduct expenses that she could substantiate that exceeded income, but imposed penalties for unsubstantiated expenses that she also deducted.
Take Away The ruling further emphasis that the common man litmus test which most folks know that state that a business needs to make profit in 3 out of 5 years is not the determining factor. Although, each case is based on its facts and circumstances, how business is conducted and the intent of the owners to make profit. Whether an activity is a business or a hobby is a question of facts and circumstances. The court found that the taxpayer had an honest intent to make a profit and that she conducted her activities in a business-like manner, even though her income was minimal.
The taxpayer opened a hair-braiding salon in 2004. She undertook reasonable, if limited, marketing efforts, including ads, brochures, and a website. She maintained a separate bank account and kept business records. For 2011, the year at issue, she earned $82,500 as an event planner. Her hair-braiding salon had gross receipts of $325 in 2011 and expenses of $16,100, including rent of $13,000 and other expenses for hair products, phone, web site maintenance, cell phone, and supplies.
To deduct business expenses without limitation, the taxpayer must show that she engaged in the activity with an actual and honest objective of making a profit, not as a hobby or for recreation. Although a reasonable expectation of profit is not required, the taxpayer’s profit objective must be actual and honest. The court considered the nine factors in the regulations and found that the only factor against the taxpayer was the salon’s persistent history of losses. Most factors were neutral. The court concluded that the taxpayer conducted her business with an actual and honest profit-making objective. She had a genuine profit motive when she opened the salon. The business failed for reasons beyond her control. There was no element of pleasure in the activity (sitting in an empty booth in a shopping mall hoping for customers).
The taxpayer lacked substantiation for some of her expenses: supplies (which were for meals), $410 of hair products, and cell phone expenses (which may have been personal in any case). These were not deductible. Furthermore, a 20 percent accuracy-related penalty was imposed for failing to keep adequate books and records or to substantiate items despite understanding the need to keep records for several categories of expenses.
If you have any questions regarding your business and determining if it is a hobby, please do not hesitate to contact us.