The Hobby Loss Rule: How to Defend Your Business Against the IRS

Jeremy explores the hobby loss rule through the landmark case of artist Susan Crile, who successfully defended her art business against IRS claims despite reporting losses in nearly all of 25 years. The episode breaks down the nine-factor test used to determine whether an activity has a genuine profit motive, examining how professional conduct, record-keeping, and business decisions matter more than consistent profitability. This case offers crucial lessons for practitioners working with creative professionals, startups, and any clients going through extended periods without turning a profit.

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Jeremy Wells, EA, CPA

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What is Tax in Action: Practical Strategies for Tax Pros?

Join Jeremy Wells, EA, CPA, as he breaks down the complexities of tax law into practical guidance you can apply immediately. Each episode focuses on a specific tax strategy, credit, or compliance issue that matters to tax professionals and business owners. Rather than theoretical discussions, Jeremy delivers actionable insights based on real-world scenarios and current tax regulations. Whether you're navigating Section 1031 exchanges, maximizing research credits, or helping clients with energy tax incentives, this podcast provides the technical details and strategic considerations you need to confidently serve your clients. Perfect for tax practitioners looking to deepen their expertise and business owners wanting to make more informed tax decisions.

There may be errors in spelling, grammar, and accuracy in this machine-generated transcript.

Jeremy Wells: One of the main reasons to run a business or make an investment is to make a profit. There's really no reason, you know, besides trying to make some money to invest your time and energy into that activity. At least that's the way a lot of people think. But there [00:00:30] are some people who think differently. There are some people who might be looking for something else out of that particular activity. Maybe they get some personal enjoyment. Maybe they're running things in such a way where they know there's going to be a loss, and that might provide some tax advantages for them. But in general, whenever we're talking about an opportunity to make money through running a business or through some sort of investment, we expect there to be [00:01:00] a profit motive. On the other hand, sometimes businesses hit rough patches. Uh, there might be rough years where they spend more than they bring in, and some businesses take a while after they start up to reach profitability. Uh, Amazon, for example, famously took several years, about 7 or 8 years before it started turning a profit. And even then it was a very modest profit for a couple of years, until it really grew to become one [00:01:30] of the world's largest and most profitable companies that it is today. But that wasn't always the case. There was a long time there where investors were nervous that Amazon was never going to be profitable. But even for small business owners and individual taxpayers, there might be activities where it's not clear whether that activity really ever has a shot at becoming profitable.

Jeremy Wells: Now business losses and [00:02:00] to a degree, investment losses are generally deductible for tax purposes, but only if that activity is engaged in for profit. But what happens if that activity never or just rarely makes a profit? Do we have to account for that somehow for tax purposes? How do we know if there's a real profit motive behind that activity? That is exactly the question that the IRS and [00:02:30] even the Tax Court has had to answer. In a lot of cases, there are a lot of tax court cases looking at activities, trying to determine whether there was, in fact, an actual profit motive. And in particular, for this episode, I want to focus on one case that happened about ten years ago for an artist named Susan Crile. Her tax court case, it's not really, uh, that presidential, uh, there's there's not really [00:03:00] anything that is significant about this case that differentiates it from a lot of other, uh, cases from this subject. But I think this one is really interesting to look at. If you're a fan of looking at the tax court and the cases and the way tax court judges think and interpret tax law, I think this can be a really instructive case and a really good opinion to read through. But in general, the topic for this episode is [00:03:30] the idea of an activity not being engaged in for profit, and that invokes something that is known as the hobby loss rule.

Jeremy Wells: In other words, tax law says that an activity can either be engaged in for profit, such as a trade or business, or an investment, or it's not. And if it's not, we have to be very careful about how we treat [00:04:00] that activity for business purposes. So that's what we're going to talk about in this episode. So for this episode, we're going to focus in on what that hobby loss rule is, what that means, and how we as practitioners have to interpret that, how we have to think about some of the activities that our clients are engaging in and what we need to be looking for in terms of trying to demonstrate that there really is a profit motive or how we need [00:04:30] to report those activities. If there isn't an actual profit motive. We're going to look at the nine factor test that comes out of the Treasury regulations to determine or help determine whether there is, in fact, a profit motive or not. Again, I think the tax court case we're going to look at is really good because the, uh, the judge's opinion goes through each one of these factors one by one, and really breaks down the case in terms [00:05:00] of those factors. And in a way that's not really as as thoroughly done in a lot of the other, uh, tax court cases that have to do with this particular topic.

Jeremy Wells: So again, I think that's an instructive case. And we're going to look at that tax court case in depth, the case of Susan Crile the commissioner. This is Tax Court memorandum 2014 202. Again, if you if you're not familiar with this case and you work with [00:05:30] self-employed clients, uh, small business clients, I strongly recommend reading through this tax court opinion and looking at how a lot of the discussion and the opinion can, uh, relate to your own clients that you're working with. It really gives a good idea of how the IRS and the court applies the hobby loss rule and that nine factor test to determine if that activity is engaged in for profit. Another interesting fact [00:06:00] or aspect of this story with Susan Crile is because she is an artist. Uh, there was a lot of coverage of her particular case in the art community. And even though the tax court opinion doesn't necessarily state, uh, this, there is a sentiment in that coverage that this case really was for the benefit of the [00:06:30] entire art community, that it showed that artists can, in fact, operate their art creating businesses, uh, as businesses. And that just because the creative professions and especially, uh, art are not necessarily, uh, high profit endeavors. That doesn't necessarily mean that those activities are not for profit activities. [00:07:00] So again, there's a really instructive case.

Jeremy Wells: It's a case that could have implications for a lot of other professions and maybe even some of your own clients as well. So let's start off with the general rule here. Activities carried on as a hobby, a sport or for recreation are not considered activities engaged in for profit. Again, when we're looking at activities, there [00:07:30] can only be two kinds, and every activity has to be one or the other. It's either engaged in for profit or it's not. If that activity is not engaged in for profit, then expenses from those activities generally fit under the personal, living or family expenses of IRC section 262. And so therefore they're not considered trade or business expenses. Under IRC section 162, [00:08:00] the expenses falling under section 262 are not deductible generally for individual taxpayers. And on top of that, IRC section 183 tells us that losses from personal activities, including these kinds of hobbies, sport and recreational activities are not deductible. That is [00:08:30] what's known as the hobby loss rule. Expenses for hobbies are not deductible as trade or business expenses. And losses from those kinds of activities are also not deductible. Now trade or business activities and activities for the production of income are considered to be activities engaged in for profit. Those expenses from those activities [00:09:00] generally fall under that category of ordinary and necessary trade or business expenses that we see described in IRC section 162. Losses from those activities typically are deductible within the constraints that we get in other sections of the Internal Revenue Code.

Jeremy Wells: So for example, there might be passive activity loss limitations. There might be basis limitations on how much of those losses we can deduct. However, [00:09:30] in general, losses from for profit activities or from production of income activities generally are deductible. The expenses are deductible to the extent that they're ordinary and necessary under section 162. And that's all covered in IRC section 183 C. So the rub here for the taxpayer is that the income from these kinds of hobby, [00:10:00] sport or recreational activities. And for the purposes of the rest of this episode, I'm just going to refer to these as hobbies. Hobby income from those activities not engaged in for profit is still included in taxable income. The gross income from those activities is still reported as income. In fact, it's reported as additional income on the tax return. So that's going to be included on schedule one, which is going to flow into [00:10:30] gross income on form 1040, even if that activity is not engaged in for profit or there's no intent to produce income, if there is income from that activity, it adds to taxable income. But the reverse is not true. Those losses are not deductible. In fact, because this is not a trade or business activity, the expenses are not deductible. There is an exception. Cost [00:11:00] of goods sold are deductible from the gross income from a hobby activity or an activity not engaged in for profit.

Jeremy Wells: And this comes, uh, back in. That's important for a lot of, uh, certain kinds of specialty farming activities, especially those dealing with livestock breeding activities. So horse breeding, uh, dog breeding, those kinds of activities where it's [00:11:30] more of a personal nature, where there's not really a breeding business, there is no for profit activity going on. However, there is the production of income from those breeding activities, in those cases, XZ the cost of goods sold that go into that business. Those direct costs are a reduction of gross income. However, none of the other what we might call indirect expenses or ordinary expenses are [00:12:00] deductible. Now the expenses were deductible. Used to be deductible as a miscellaneous itemized deduction. However, since 2018, the Tax Cuts and Jobs Act suspended miscellaneous itemized deductions between 2018 to 2025. And then, of course, the one big beautiful Bill act. The Oba made that suspension permanent. So there is no more miscellaneous itemized deductions. [00:12:30] That means there are no more deductible expenses for hobby activities. So the income is reported as part of gross income. The expenses are nondeductible and if there is a loss from that activity, that loss can't be taken generally under section 183. So this is really a heads I win tails you lose situation for the IRS. If you have a [00:13:00] hobby activity the income is taxable. But the expenses and the losses are nondeductible. It's important to keep that in mind.

Jeremy Wells: Now that's not true. For a for profit activity such as a trader, a business or an activity for the production of income. So it's the taxpayer's preference to try to convince the IRS and a court if it gets to that, that that activity was in fact engaged in [00:13:30] for profit. However, it's the taxpayer's burden generally to prove that. And I'll talk about that a little bit more, especially when we get into the Creole case. It's important to understand, first of all, though, that this is particular to individuals, estates, trusts, partnerships and s corporations. The hobby loss rule does not apply to C corporations. C corporations do not have to worry about the hobby loss rule. [00:14:00] You can have a business that is organized as a C corporation, that goes through years and years of losses without having to worry about any limitations due to the hobby loss rule. And so back to the example that I opened this episode with of Amazon. Amazon was a C corporation pretty much from the start. And so that's why for a lot of businesses that grow to become national or international brands, you don't really have to worry about [00:14:30] the hobby loss rule that much. So mostly we're talking about relatively small businesses, small operations, individual taxpayers doing activities. That's within the scope of just one, maybe a couple of people. However, it's important to remember that the hobby law's rule applies to virtually any kind of organized activity, whether that's individuals, partnerships, estates, trusts, or even s corporations.

Jeremy Wells: Does not apply to C corporations, but it is possible for [00:15:00] an S corporation or a partnership to be subject to the hobby loss rule as well. And for those, the limitations on the activities not engaged in for profit are determined at the partnership or s corporation level. That's where the determination is made. So this is not made at the individual shareholder or partner level. It's made at the entity level. And then whether those, uh, deductions or losses [00:15:30] are disallowed due to the hobby loss rule, that's going to affect the individual partners or shareholders respective shares of income, deduction, loss or credit from that entity. Now, it might be a little difficult to imagine organizing a partnership or an S corporation, especially around an activity that is not engaged in for profit. In fact, it [00:16:00] could help the taxpayer in terms of arguing that the activity is in fact engaged in for profit. If there is some sort of organized entity there, such as an LLC that's either treated as a partnership or an S corporation for tax purposes, however, that might help. But it doesn't guarantee that the IRS and the courts are going to see that activity as engaged in for profit. The [00:16:30] taxpayer would still have the burden of proof there. So just registering an entity such as an LLC or just making a tax Action, such as electing to be an S corporation, doesn't necessarily guarantee that that taxpayer is not going to have to worry about the hobby loss rule, so it's important to keep that in mind as well.

Jeremy Wells: There are a lot of activities that a taxpayer might, for various reasons, think that registering some sort of entity at [00:17:00] the state level, especially an LLC, will somehow, uh, get them out of having to worry about the hobby loss rule. That's not true. Just because you've registered an entity, even made some advanced tax selections for that entity, doesn't necessarily mean that that activity has now, uh, going to be considered to be for profit. It could still be considered not engaged in for profit, and you're still going to run into the hobby loss rule issue. The the fact that the limitation [00:17:30] comes at the partnership or the s corporation level is important to keep in mind, especially if you're preparing the returns for those entity types that comes from Treasury Regulation 1.1 831F. Now, like I said, the taxpayer bears the burden of proving a profit motive. In general, courts will give greater weight to objective facts than to a taxpayer statement of intent. In other words, I can start and run an activity for several years. It never makes [00:18:00] a profit. I can say I'm hoping to make a profit someday, but what the courts are actually going to look at is all of the objective factors that go into how I'm operating that activity, not just my claim that I'm hoping to make a profit someday with it.

Jeremy Wells: The taxpayer's expectation of profit doesn't have to be a reasonable one, though. It's sufficient if the taxpayer has a bona fide expectation of [00:18:30] realizing a profit, regardless of the reasonableness of that expectation. In other words, There's a little bit of an allowance for the fact that some people are, for lack of a better way of putting it, might be a little crazy in terms of their entrepreneurial spirit. The everyone that knows that individual, their family, their friends, their business associates might be telling them that it's a bad idea. If that individual truly believes that there is hope for profit in [00:19:00] that activity, then that's generally at least as far as the courts are considered, are concerned. That's generally going to be good enough for them now. They're still going to be the burden of proof for the taxpayer to convince the court that the taxpayer really does truly expect to make a profit. But we can't just look at the business and say, that idea will never work. Therefore, there must not be a profit motive. If the taxpayer can [00:19:30] convince the courts that there truly is a profit motive, no matter how remote the chances or likelihood of a profit, no matter how crazy everyone thinks that idea is, if the taxpayer genuinely believes there is a chance of a profit, then that activity, at least as far as the courts are considered, could be a for profit activity.

Jeremy Wells: There's a lot of case law from the tax court. A lot of this has been reviewed by appellate courts and affirmed [00:20:00] that supports this holding by the tax court. So you get a lot of tax Court memoranda, cases that have been upheld through the appeals process that go along with this contention. Let's get into the specific case that we're looking at in this episode. So who was who is Susan Crowl? She's still alive. Susan Crile was a at the time of the, uh, [00:20:30] case. She was a tenured art professor at a university. She received an IRS Notice of deficiency in 2010 for tax years 2004, 2005, and then 2007 through 2009. So several years there. And depending on the actual story, that's what the, uh, the facts stated in the tax Court memorandum. Uh, give us, uh, there there's also [00:21:00] an interview that she gave that's available online. Uh, about a year after the decision from the Tax court was handed down, where she explains it as though, uh, initially the terms of the audit, the IRS audit were much more specific. And then they broadened over time. Uh, regardless, by the time we get to the tax court, there are now these five years 2004, [00:21:30] 2005, 2007, eight and nine that are under review by the Tax Court here. Now, as an artist, her expenses regularly exceeded her gross income from selling her artwork.

Jeremy Wells: She typically had losses. In fact, the Tax Court ended up looking at a time period of almost 25 years. And in all of those years that she reported as a business, uh, her, [00:22:00] uh, artist work, that she only had about two years where she actually reported a profit, uh, for tax purposes. All of that was done on a schedule C, uh, attached to her. 1040, by the way. But for most of those years, for the for the majority of those years, uh, she had losses and those losses for the years under review by the court. Those losses range from about 37,000 to $63,000 for those years. So, uh, you know, they weren't they weren't major losses. They weren't in the millions. [00:22:30] Um, but at the same time they also were relatively significant to her as well. The deficiency notice with the assessed uh, tax plus penalties and interest was going to be tens of thousands of dollars worth of tax for her. Uh, and as a university professor and a struggling artist, that was going to be a lot more money, uh, than she was able or willing to pay. So [00:23:00] she pursued, uh, the audit, she challenged the IRS, and the case wound up in the tax court. She actually said in that interview she gave about a year after the decision came down, uh, that she really felt like this was a test case for the IRS, that the IRS was not necessarily going specifically after her, but really trying to explore, uh, the art industry as a whole and see how far the IRS [00:23:30] could go in terms of auditing artists.

Jeremy Wells: Now, again, if that's her opinion, that's not anywhere in the record either in the tax court record or the IRS record. But there is an aspect to this case where it feels like the IRS is more just trying to figure out what's really going on with these struggling artists situations in terms of how they're preparing and filing their tax returns. Now in court, the IRS made two arguments that the court considered. [00:24:00] The first one was that her activity as an artist was not engaged in for profit. And that's the that's the bulk of the case. It's the bulk of the opinion that the court passes down, and it's the bulk of what we're going to focus on here in this episode. But the IRS actually made a second argument as well, that I'll talk about later on in the episode, was that her activity as an artist was part of her work as an art professor. So in other words, her artwork business should not have been reported [00:24:30] as a business on her schedule. See that? In fact, the expenses for that activity should have been considered unreimbursed employee expenses that would have been reported on a schedule A again as a miscellaneous itemized deduction. Because this case was heard in 2014 as evolving tax years quite a bit before Tax Cuts and Jobs Act, when we still had miscellaneous itemized deductions.

Jeremy Wells: So in that time period, that argument had a little bit of, [00:25:00] of made a little bit of sense, right, that it could have made sense to say the what she's paying out in order to create this artwork as an art professor should be recategorized, not as business expenses, but as unreimbursed employee expenses. This is going to get dealt with by the court as well. But really the focus of this case is just on whether her activity is actually engaged in for [00:25:30] profit, whether it is a business. Because the Tax Court's take on this is that if we can establish that she actually engaged in this activity for profit, and it's a distinct activity from being a university professor, then we don't really have to worry about that second question so much. Um, although the court does address both of them now, there is actually a third question in this particular case, and that has to do with whether her expenses truly [00:26:00] were business expenses, meaning they were ordinary and necessary under section 162. In this particular opinion, the court decided to make a separate opinion for that. I looked I couldn't actually find it. I don't know if because of the opinion that we'll talk about in this case, that second case dealing with the actual expenses and whether they truly were [00:26:30] ordinary and necessary business expenses, and therefore deductible or not.

Jeremy Wells: I couldn't find if that got picked up. Uh, I couldn't find another tax court opinion, uh, in the matter of Krile v Commissioner, however, uh, assuming that, uh, you know, that got picked up based on the way this case got handled, I think that might have been resolved directly between, uh, krile and the IRS, or after the way this case got, uh, decided IRS should drop the whole matter against Krile [00:27:00] entirely, although I'm not sure, uh, what actually happened there. So let's look at the factors. The nine factor test that actually goes into, uh, attempting to determine whether an activity is actually engaged in for profit or not. The regulations in uh, section 1.1 832B provides a nine factor test. And a lot of this is based on tax court opinions that had come out before [00:27:30] the promulgation of these regulations. So in this case, what you actually get and this happens other places in tax law as well. But what you get is there is some lack of explanation of how a rule in tax law actually works. The courts have to make up some rules or some frameworks for thinking about how to interpret tax law. And then the courts consistently use that framework over and over, [00:28:00] to the point at which Treasury and the IRS decide, let's just make this part of our regulatory law or our administrative law. And so this particular part of the regulation actually came out of a lot of consistent frameworks that were in the tax court cases, having to do with the hobby loss rule, with activities engaged and not engaged in for profit.

Jeremy Wells: And then all of that generally under the heading of [00:28:30] IRC section 183. So the nine tests here are the manner in which you carry on the activity. I'm just going to go through this list fairly quickly, because we're going to break down each one of these looking at trials case. So the first one is the manner in which you carry on the activity. Then your expertise or the expertise of your advisors. It doesn't have to all be on you. You can rely on some advisors, but those advisors need to know what they're talking about. Your time and effort expended on the activity, [00:29:00] the expectation that assets used in the activity may appreciate in value your success. Carrying on other similar or dissimilar activities your history of income or losses with respect to that activity, the amount of occasional profits, if any, which are earned. Your financial status, and then whether elements of personal pleasure or recreation are involved. Those [00:29:30] are the nine factors listed in the section 183 regulations. And that's essentially what Treasury and the IRS are going to use in their first analysis of whether an activity is engaged in for profit or not. And because, uh, those uh, factors have been, uh, put into the regulations, that's actually become the framework that the tax court uses to look at these activities, and in particular in [00:30:00] this case with Crile.

Jeremy Wells: What we see is the judge actually breaking down the opinion in terms of each one of these factors. So first of all, professionalism and record keeping, uh, are part of how the court looks at how a, an owner is running, uh, an activity and managing an activity. And the better the record keeping, the more professional and businesslike that taxpayer runs that activity, the [00:30:30] more likely it is that there really is a profit motive. Now, it's important to keep in mind, before we get into these, that no single one of these factors determines whether an activity is engaged in for profit or not. In fact, you'll see this in a lot of the court opinions. You'll even see this in the regulation as well. None of these factors are determinative. So it's not like you can just look at one factor and say, oh, because we can check this box off. It must be engaged in for profit. In [00:31:00] fact, there can even be a preponderance of checking boxes off with these nine different factors, and yet still a determination that the activity was not actually engaged in for profit. These factors merely exist as a framework for helping us think about whether an activity is engaged in for profit or not. They don't actually help us determine. So it's not a scoring system. It's not a rubric.

Jeremy Wells: We're not trying to check off boxes [00:31:30] and say if we get a certain number, such as five out of nine or something like that, that we can therefore make any sort of determination about this activity. We still have to independently look at the activity and determine whether or not there is a profit motive. What these nine factors give us is an indication of whether we are leaning toward considering that activity, having a profit motive or not. So in this first factor, we're looking at whether [00:32:00] the activity is conducted in a business like manner. Now, Crile kept relatively good records, according to the the court's opinion of her sales of the galleries and exhibitions that her artwork was displayed in. She kept decent records of this. She worked with a bookkeeper for most of the years in question. There were 1 or 2 years where she did not work with a bookkeeper, but for most of those years in question, she actually did. And she also made [00:32:30] business like decisions. This was another factor that I found interesting in the court's discussion, because I'm a big fan of record keeping, good record keeping, that's necessary. And I'm a big fan of conducting your business in a professional manner. I think keeping good books and records is part of that. Filing tax returns on time is a good reflection of that. Working with tax and accounting professionals and advisors is good there. But she also made [00:33:00] good business like decisions, according to the court.

Jeremy Wells: So, for example, when she felt like the gallery that she was displaying her artwork in no longer fit her particular kinds of work, she made a business like decision to change to a different gallery. Uh, Crile has a particular kind of art that she's portraying, and she, uh, has a particular kind of messaging that goes along [00:33:30] with her work. And she felt like the gallery that she was in no longer was a good fit for that messaging. And so she found a gallery that would have a better fit. Now, it's not just that she disagreed with the messaging of the first gallery, it's that she knew that potential buyers of her artwork will probably would not be attending exhibitions and events at the gallery that she was in. So, according to, uh, the court, she made a business decision [00:34:00] to move her work to another gallery where she would probably, uh, be more in line with the clientele there. She also arranged shows and promoted her own work. The court said, quote, uh, petitioner's marketing efforts demonstrate a profit objective right there. There are some lines in this case where you're thinking, if you could get a sitting judge to write this about your particular business, you [00:34:30] must be doing things pretty well. So for a judge of the Tax court to say that a taxpayer's marketing efforts demonstrate a profit objective, and you're in a case trying to determine whether or not your business has a profit motive, that's a pretty strong indicator in your favor.

Jeremy Wells: The next one is that Crile got advice from other art professionals, especially those working for the galleries. And then she herself, after being [00:35:00] in the art making business for quite a bit of time, and especially being an art professor herself, demonstrated that she definitely had expertise on her own. So taxpayer's taxpayers expertise, research and study of the accepted practices in an industry, as well as consultation with other experts, could indicate a profit motive in general. Her advisers again were mainly her [00:35:30] galleries, and because of that, the IRS tried to make a claim that she didn't understand the economics of selling art. She knew how to make art, but she wasn't in the business of just making art. She was in the business of selling art. And again, the court disagreed. The judge said, quote, she understood the general factors that affect the pricing of art. A History of sales, gallery representation, solo exhibits, critical reviews, prestigious public [00:36:00] accolades, and she worked diligently to achieve these credentials. She is, without doubt an expert artist who understands the economics of her business. Again, if you could get a judge to say that you are an expert in your field and you understand the economics of your business. That is a pretty outstanding, uh, statement for a judge to make about you and your business. So, um, I don't think you could get much more of an affirmation, [00:36:30] uh, that, you know what you're doing than than that statement right there.

Jeremy Wells: It was clear to the court that Crowell, uh, devoted significant time to her, uh, business as well. So the fact that a taxpayer devotes considerable time and effort to an activity is the third factor that indicates a profit motive. Especially time spent on the mundane, essential tasks [00:37:00] that are not necessary for whatever that activity actually is. What does the court mean by this? So the court uses the example of grooming horses as that kind of mundane task that you have to do in a horse grooming activity in horse grooming is one of these typical activity not engaged in for profit kind of activities. [00:37:30] It's generally essential to groom feed the horses in that activity, and whether you're trying to make a profit or not, you would still have to do that. If you had a dog breeding business, you would still have to feed and groom the dogs. That stuff doesn't count toward the time that you're spending on that activity in establishing whether or not there's a profit motive. But for krile, those mundane [00:38:00] tasks, such as marketing and networking with potential collectors is the example that the court gives were essential only because she was conducting a business. And that's what that's what the court actually says, that they would have been unnecessary if she were pursuing a hobby.

Jeremy Wells: So there the mundane tasks that are part of running a business, and they're necessary to run a business, but they're not necessary for a hobby. If you have a hobby of painting, you [00:38:30] don't necessarily need to be worried about finding galleries and trying to find buyers if you're only doing it as a hobby. But if you're trying to live off of it, if you're trying to make it a business, then that work absolutely is necessary. So this was another, uh, bit of support in favor of there being a profit motive here. Now, the other issue here is that she had a job, uh, especially for the years in question. However, having another job doesn't necessarily detract [00:39:00] from, uh, whether there is a profit motive or not, because a taxpayer, the court said, is is welcome to engage in more than one trade or business simultaneously. There's nothing in tax law saying that you can only be engaged in a single activity for profit, at any given time, just because you're doing something on the side that is not your main employment doesn't mean that it's necessarily a hobby. In fact, [00:39:30] the fact that Kyle was an artist for about a decade before she got the job teaching at a university enhanced her standing with art professionals, art critics, museum curators. It enhanced her business. If anything, it wasn't that her job was taking away from her art creation or that creating art was taken away from her job.

Jeremy Wells: If anything, they were synergistic with each other. She spent about 30 hours a week. She [00:40:00] testified to the court during the parts of the year where she actually taught, and then she worked full time creating art the rest of the year. So even though she was full time employed as a professor, she was spending a significant amount of time really. She was practically working full time in the art creating business while also having a full time tenured teaching job. So the court definitely considered this sufficient as significant time. There was also an expectation of value appreciation, [00:40:30] uh, which strongly indicated that there was in fact a profit motive. Now, artwork, uh, the market for artwork tends to fluctuate, uh, quite a bit. In fact, in fact, there was a discussion, uh, from one of the expert witnesses in this case about the art market in a couple of the years in question, especially 2009, 2010, because [00:41:00] of the 2008 financial crisis, in 2008, 2009, 2010, the art market took a pretty significant hit. Crile was based in New York City, and one of the experts testified that the the art market in New York City during the financial crisis basically completely dried up, that there was virtually no demand for art. Um, and so just because a particular industry might [00:41:30] have some economic effects that cause business to shrink or dry up a little bit doesn't necessarily mean that, uh, it's no longer engaged in for profit.

Jeremy Wells: Even if the taxpayer, uh, derives no profit from current operations, then it's still reasonable to expect overall profit when asset appreciation is factored in. What, uh, Crile did and what most artists [00:42:00] do is they create a lot of inventory. And that inventory might be in the artist's Workshop, but a lot of it ends up going out into galleries and exhibitions, which is where clientele actually sees and considers purchasing it now until there's an actual purchase made. A lot of that inventory is relatively low value, because there's no determination as to whether it's actually going to sell for anything. However, in [00:42:30] a lot of these creative professions, all it takes is one really good showing. Or maybe one particular collector gets really interested in a particular artist's work, and pretty soon you have a significant appreciation in the value of almost all of that artist's work. And so when we're looking at an an expectation of value appreciation for art, that's generally going to be there as long as that artist [00:43:00] is known in the community, has a clientele, is exhibiting their work, and Crile was definitely doing all of that. And of course, art can appreciate over time. A lot of artwork does. And so those profits may just come later. Success in other activities can factor in here as well. Having a track record of success in other business ventures may actually indicate that the taxpayer has the entrepreneurial skills [00:43:30] and determination to succeed in subsequent endeavors.

Jeremy Wells: So this is a way to factor in how the particular taxpayer has performed in other, even unrelated efforts to the one to the activity in question. So this could imply that the taxpayer, when pursuing this particular activity, does so with the expectation of making a profit. If that individual has been successful in other activities, [00:44:00] then we might be more willing to consider that that taxpayer is trying to be successful in this activity as well. Now, on the other hand, if this individual doesn't really have any history of trying to create a profitable enterprise or has no experience or any, uh, demonstrated ability to do so in other fields, then that might be a strike against, uh, our consideration that [00:44:30] in this particular activity, the taxpayer is trying to do so. Although again, none of these are determinative, especially not in isolation. In other words, you know, we all have to start somewhere. So just because it's your first activity and you don't have a history of running profitable activities, doesn't necessarily mean that this activity, uh, isn't going to be profitable. Her success really, uh, as an artist really started [00:45:00] when she became a professor that really opened more doors to her. It got her a lot of recognition among her clientele. However, that didn't start until about a decade after she started creating artwork. She had already been an artist for quite a while at that point, so the court held that, uh, that success in academia really came after, uh, her starting work as an artist.

Jeremy Wells: But because she, [00:45:30] uh, grew into that position, she expanded her clientele, she expanded her notoriety. And then that may have factored into her prospect of actually flourishing as an artist. So, again, there was a bit of a synergistic effect there, although for this point in particular, uh, the court found that it was it wasn't really supportive of either, uh, side in the case. Now, in that interview that Crile did after the case, after the opinion came down, she argued that [00:46:00] her museum shows and her collections proved market validation. But this point really isn't so much about market validation for that particular activity. It's more about are you just in general, uh, successful in your, uh, entrepreneurial activities throughout your entire life, whether they're in activities that are unrelated to the one in particular that we're looking at. But the court did take into account the [00:46:30] fact that she was a successful professor. She became a tenured, uh, university art professor, and that that did have some effect on her perception of her ability to flourish as an artist. The next factor is a history of losses. Um, now this one. This is where the case starts to turn a little bit against, uh, her. So the fact that a taxpayer incurs a series of losses beyond an activity startup years, uh, tends to imply [00:47:00] the absence of a profit objective.

Jeremy Wells: Now she had several years of substantial losses, but the court concluded that those losses may have resulted at least somewhat from reporting personal expenses as business expenses. So again, there was a third question in this case as to whether all of those business expenses truly that got reported on the return truly were business expenses. And so even though the court didn't get into adjudicating that part of this case, the court did take into account the fact [00:47:30] that maybe her losses weren't as significant as she reported. And for some of those years, they may have even been a profit, after accounting for the fact that at least some of her expenses probably weren't actually, uh, deductible. They also took into account, again, expert testimony that the 2008 financial crisis had a pretty significant effect on the art market in general, especially as well as, uh, her business. But the court also came back and said that she had losses all the way back to 1996 [00:48:00] up to 2007, again for about a 25 year period. She only had two years where she showed a profit for tax purposes. So, um, this actually ended up being her weakest, uh, opinion. In fact, the court stray just just straight up said that this was the IRS. The IRS won this point. But the court also reminded us that, again, no single factor is determinative, that losses do not negate the petitioner's actual and honest intent to profit from the sale of her [00:48:30] art.

Jeremy Wells: Occasional profits, uh, indicate can indicate a profit motive. The fact that a taxpayer derives some profits from an otherwise money losing venture can support the existence of a profit motive, and then also a substantial, ultimate profit following considerable losses may sufficiently indicate a profit motive in the regulations. The example of wildcat oil drilling is given here that you might have a long period of significant [00:49:00] losses trying to get set up with the goal of literally striking it rich. And in a way, the art industry can function like this. Again, it takes one good show or one good client to completely turn around an artist's entire career and livelihood. The court said that art is a speculative venture where a single event, a solo show, a rave review or a museum [00:49:30] acquisition can lead fairly suddenly to an exponential increase in the prices paid for an artist's work. So with just two years of reported profits, the court held that this factor weighed slightly in favor of the IRS. But it's clear that the court is sympathetic to Krile, especially on this particular point, because, again, as an artist, she's waiting for that moment when things truly do turn around for her from a business perspective and then lack of income [00:50:00] from other sources. So looking at the taxpayer's complete financial picture. Now she is full time employed, uh, with a job, but she was an artist for over a decade before she got that university job.

Jeremy Wells: She did not become an artist in order to shield her other income from taxes. That's really what this particular factor is getting at. Some of these not for profit activities are created and [00:50:30] run just in order to generate a tax loss. And so really it's more of a personal activity. It's a hobby. And it's something that honestly is a good write off against ordinary earned income. Just because it's a tax loss doesn't necessarily mean that, uh, you know, it's possible to deduct that loss. In fact, that's the purpose of section 183, is to prevent taxpayers from running activities purely for [00:51:00] the purpose of being able to deduct that loss against their ordinary income. Now, the court found this point supported neither side really definitively. She earned the salary and a little bit of income, modest income from other investments, uh, all income outside the art business. But then, uh, you know, really she really insisted that this was her life's work, that this art business really was, uh, what she was, uh, focused on. And then the [00:51:30] final factor here is personal pleasure. Um, if the taxpayer gets a lot of just personal pleasure out of the activity, then that that tends to work against trying to prove that there's a profit motive. But in general. Right. You know, very few people get into business because they, uh, you know, just hate it.

Jeremy Wells: Right? Most people get into business because they they actually enjoy the work that they do, or they enjoy certain aspects of what being self-employed means. [00:52:00] It gives independence, it gives freedom. It gives opportunity to run the activity the way you want. In fact, the court quoted part of another case opinion a level of suffering has never been made a prerequisite to deductibility. You don't have to hate the work that you're doing in order to convince anyone that there's a profit motive. You can love what you're doing. You can be passionate [00:52:30] about it even. But in general, that needs to be the result of success in that activity. It can't just be an activity purely for personal pleasure, and then it just happens to make some money or have a loss associated with it that there needs to be some sort of profit motive, independent of the the personal pleasure that you get out of that activity. Now, Crile committed [00:53:00] significant effort into extensive research, marketing efforts and running the business. And so the court said that there is a level of seriousness in her activity that takes it well beyond the realm of recreation. In other words, she actually ran it like a business. So to summarize here, the court found that she definitely carried on her business in a professional way. She demonstrated expertise in a reasonable reliance on professional advisers. She committed significant time and [00:53:30] effort to the activity. She had a reasonable expectation of appreciation and the value of her product.

Jeremy Wells: Now, her success as an artist and an art professor, her financial status and her personal pleasure in the work, those were neutral or just slightly favored her. And then the history of losses and lack of profitability helped the IRS. But overall, none of that was convincing enough to sway the court in favor of the IRS. In the end, the court sided with Krile. [00:54:00] Uh, the court said that in a qualitative as well as a quantitative sense, that the balance of factors favored krile, and that she met her burden of proving that in carrying on her activity as an artist, she had an actual and honest objective of making a profit. So, uh, therefore, the court found that the activity was in fact a business, that she was allowed to deduct her section 162 ordinary [00:54:30] and necessary business expenses, and that any losses resulting from that activity were actually deductible, uh, for her. Now, there's a presumption of a profit motive rule that is part of section 183 as well. This is often stated as the three of five year rule, although for any activity involving, uh, breeding, training, showing or racing horses, it's actually two out of seven years. So when I say three out of five year [00:55:00] rule, know that for those horse related activities, that's actually two out of seven years. But I hear this, uh, misstated a lot as an activity. Can't lose money for three or more years before it's not deductible.

Jeremy Wells: The loss from it isn't deductible. That's actually not what the presumption says. All it says is that the burden of proving whether an activity is not engaged in for profit shifts from the taxpayer to the IRS, [00:55:30] if the activity meets that safe harbor presumption. Now, even if the activity does meet that safe harbor presumption, the IRS can still determine that that activity is not engaged in for profit, and an activity cannot have profits for more than three years and still be an activity engaged in for profit. It still is a matter of facts and circumstances for that particular activity. What this safe harbor does is it creates a presumption [00:56:00] in favor of the taxpayer that if there is profit in any three of five consecutive tax years, that it is presumed to be an activity in engaged in for profit, and that it's up to the IRS to prove that it isn't. Now, that presumption applies to the third profit year within a five year period, or the second profit year within a seven year period for those horse related activities. And then each subsequent [00:56:30] year within a 5 or 7, depending year period beginning with the first profit year. So you really have to look at the first year of profit and then go five years forward from there to look at that three out of 5 or 2 out of seven year period.

Jeremy Wells: There's an election to postpone this. However, uh, the key to understanding this is that preemptively filing that election would trigger the IRS looking at that activity [00:57:00] as potentially not engaged in for profit. So you really don't want to make this election until you have to, meaning that the IRS is claiming that this activity is not engaged in for profit. But what that presumption, what that election does is that for any new activity that hasn't generated three years of profit, so you can't appeal to that presumption yet you need three out of five years of profit. So if there's a new activity [00:57:30] that has not yet generated three years of profits, then the taxpayer can elect to postpone that determination until the taxpayers engage in the activity for a full five year period. So let's let's sum this up right. I think Crile's case is a good example of how we can take tax law that that can honestly be a little restrictive for taxpayers and can be a little confusing to understand and [00:58:00] apply it directly to an ordinary taxpayer's situation. Again, if you work with small business owners, I strongly recommend reading through this opinion. Her case actually ended up making national headlines. It probably helped that she was an artist in New York. Um, but it made national headlines. There's there's good coverage of it. Reading through the interview she gave after it is actually really interesting from a tax professionals perspective to get a taxpayer's perspective [00:58:30] on what going through an audit and a tax court case felt like.

Jeremy Wells: For her, the coverage indicated that the ruling protected artists livelihoods by confirming that their work could be business like. Businesslike, I. I do think that that meme of the starving artist can be a bit problematic for a lot of creative workers and especially creative entrepreneurs. And so I think this could be a really good case if you work with those kinds [00:59:00] of taxpayers and those kinds of clients. But of course, each case is different. It's entirely up to the taxpayer to conduct an activity in a professional and business like manner in order to avoid the hobby loss rule. So we really need to look at the specific facts and circumstances with our clients cases and advise them accordingly. So documentation and record keeping is key. Document as much as possible and advise your clients to document as much as possible. Part of the reason Crowell [00:59:30] was successful is because she had a really good documentation system of her income, her expenses, and then all of the work that she had produced and her efforts to market that work that really came in to be beneficial for her, and I think that had a lot to do with swaying the court in her favor. Understand the business model of the industry or profession of your client. Understanding how the art industry works was key to this case. Crile [01:00:00] brought in expert witnesses to testify on her behalf and explain to the court how the art industry works.

Jeremy Wells: And it's really interesting reading through the opinion to see how that influenced the court's decision as well. Know that having a profit motive isn't the same as regularly making a profit. The key question for us when working with self-employed clients that are going through rough patches where they're not showing a profit or they're struggling to start generating a profit in [01:00:30] their startups, is not that they need to start making a profit or they're going to have tax problems. Rather, we need to demonstrate that they have a profit motive. And again, we do that through documentation. This case is a great example of seeing how technical rules and factors at play, uh, actually work out in a real life scenario. But I think what's also really interesting here is because of the coverage that came out after that, and especially that interview with Kral, we got to see the human side of the story [01:01:00] play out. There was a lot more that followed up after reading through the Tax Court opinion, and putting those two together was actually really interesting in this case, and I think it mirrors how we deal with our own clients quite a bit. So if you're working with self-employed workers, get to know them, make sure that they're documenting things well, so that when they go through those periods of losses, you've got the ability to make a solid case for them that that activity is, in fact, still engaged in for profit, and they don't get caught by the hobby loss rule.