TIGTA comments on hobby losses. Curiously, TIGTA has identified loopholes in the law on “hobby losses.” Treasury Inspector General for Tax Administration (TIGTA) Report: Significant Challenges Exist in Determining Whether Taxpayers With Schedule C Losses Are Engaged in Tax Abuse (Reference Number: 2007-30-173)
September 17, 2007
Treasury Inspector General for Tax Administration (TIGTA) report: Schedule C losses: Tax abuse. --
TREASURY INSPECTOR GENERAL FOR TAX ADMINISTRATION
Significant Challenges Exist in Determining Whether Taxpayers With Schedule C Losses Are Engaged in Tax Abuse
September 7, 2007
Reference Number: 2007-30-173
This report has cleared the Treasury Inspector General for Tax Administration disclosure review process and information determined to be restricted from public release has been redacted from this document.
Redaction Legend:
1 = Tax Return/Return Information
Phone Number | 202-927-7037
Email Address | Bonnie.Heald@tigta.treas.gov
Web Site | http://www.tigta.gov
DEPARTMENT OF THE TREASURY
WASHINGTON, D.C. 20220
TREASURY INSPECTOR GENERAL FOR TAX ADMINISTRATION
September 7, 2007
MEMORANDUM FOR COMMISSIONER, SMALL BUSINESS/SELF-EMPLOYED DIVISION
FROM: Michael R. Phillips
Deputy Inspector General for Audit
SUBJECT: Final Audit Report -(Audit # 200630039)
This report presents the results of our review to determine what actions the Internal Revenue Service (IRS) is taking to address noncompliant, high-income1 Small Business/Self-Employed (SB/SE) Division taxpayers who claim business losses using a U.S. Individual Income Tax Return (Form 1040) Profit or Loss From Business (Schedule C) for activities considered to be not-for-profit. This audit was part of the Treasury Inspector General for Tax Administration's Fiscal Year 2007 audit plan.
Impact on the Taxpayer
In general, if a taxpayer has hobby income and expenses, the expense deduction should be limited to the hobby income amount. About 1.5 million taxpayers, many with significant income from other sources, filed Form 1040 Schedules C showing no profits, only losses, over consecutive Tax Years 2002 - 2005 (4 years); 73 percent of these taxpayers were assisted by tax practitioners. By claiming these losses to reduce their taxable incomes, about 1.2 million of the 1.5 million taxpayers potentially2 avoided paying $2.8 billion in taxes in Tax Year 2005. Changes are needed to prevent taxpayers from continually deducting losses in potentially not-for-profit activities to reduce their tax liabilities.
Synopsis
According to IRS estimates, incorrect deductions of hobby expenses account for a portion of the overstated adjustments, deductions, exemptions, and credits that result in about $30 billion per year in unpaid taxes. The IRS faces considerable challenges in administrating the tax law for taxpayers who take Schedule C losses year after year for potentially not-for-profit activities. Several recent efforts demonstrate these challenges. In an effort to change noncompliant taxpayer behavior, the IRS sent letters to taxpayers with potentially tax-abusive, home-based businesses as an alternate treatment to save audit resources. However, the taxpayer response rate was low, and IRS researchers concluded that the use of letters would not necessarily be productive as a tool to induce self-correction. The IRS also conducted correspondence examinations.3 However, these examinations did not always deter taxpayers from continuing to claim hobby losses in succeeding tax years.
Internal Revenue Code (I.R.C.) Section (§) 1834 (Activities not engaged in for profit), also referred to as the "hobby loss" provision, and related Treasury Regulation § 1.183-15 do not establish specific criteria for the IRS to use to determine whether a Schedule C loss is a legitimate business expense without conducting a full examination of an individual's books and records. The purpose of the hobby loss provision was to limit the ability of wealthy individuals with multiple sources of income to apply losses incurred in "side-line" diversions to reduce their overall tax liabilities. Our analysis showed 332,615 high-income taxpayers received the greatest benefit by potentially avoiding approximately $1.9 billion in taxes for Tax Year 2005.
The I.R.C. and Treasury Regulation do not require a taxpayer to have a reasonable expectation of profit; rather, the taxpayer needs just the "objective" of making a profit. I.R.C. § 183 makes it difficult for the IRS to efficiently administer tax law that ensures taxpayers are not deducting not-for-profit losses to reduce their taxes on other incomes year after year.
Recommendations
To reduce potential abuse, the Commissioner, SB/SE Division, should provide a copy of this report to the Department of the Treasury, Office of the Assistant Secretary for Tax Policy, to consider proposal of legislative changes to I.R.C. § 183. The proposal should include establishing a clearly defined standard or bright-line rule6 for determining whether an activity is a business or a not-for-profit activity. Aside from a legislative remedy, due to the large number of tax returns with Schedule C losses being prepared by tax practitioners, the Director, Communications, Liaison, and Disclosure, SB/SE Division, should continue to coordinate with practitioner organizations to encourage compliance with existing provisions.
Response
The Commissioner, SB/SE Division, agreed with the recommendations. The Director, Communications, Liaison and Disclosure, SB/SE Division, will coordinate with the Office of Legislative Affairs to forward a copy of the final report to the Department of the Treasury Office of Tax Policy and will include key messages and talking points about I.R.C. § 183 tax obligations as a Fiscal Year 2008 outreach initiative directed to practitioner organizations. Management's complete response to the draft report is included as Appendix V.
Copies of this report are also being sent to the IRS officials affected by the report recommendations. Please contact me at (202) 622-6510 if you have questions or Daniel R. Devlin, Assistant Inspector General for Audit (Small Business and Corporate Programs), at (202) 622-5894. Table of Contents
Background
Results of Review
The Internal Revenue Service Is Aware That Problems Exist With
Taxpayers Claiming Schedule C Losses From Not-for-Profit
Activities
The Internal Revenue Code and Treasury Regulations Make It
Difficult to Determine When a Schedule C Loss Is Related to a
Business or Hobby
Recommendations 1 and 2:
Appendices
Appendix I - Detailed Objective, Scope, and Methodology
Appendix II - Major Contributors to This Report
Appendix III - Report Distribution List
Appendix IV - Methodology for Determining the Number of Taxpayers
and Potential Tax Avoided in Tax Year 2005
Appendix V - Management's Response to the Draft Report Page
Abbreviations
I.R.C. Internal Revenue Code
IRS Internal Revenue Service
SB/SE Small Business/Self-Employed
Background
The Internal Revenue Code (I.R.C.) generally allows individuals to deduct expenses only when those expenses are incurred either for the purpose of producing income (I.R.C. Section [§] 212)1 or in a trade or business (I.R.C. § 162).2 In contrast, personal expenses are ordinarily not deductible. As Supreme Court Justice John Marshall Harlan, II once wrote, "For income tax purposes Congress has seen fit to regard an individual as having two personalities: one is a seeker of profit who can deduct the expenses incurred in that search; the other is a creature satisfying his needs as a human and those of his family but who cannot deduct such consumption and related expenditures."3
The first "hobby loss" provision in the I.R.C. was enacted by the Revenue Act of 1943.4 It was popularly known as "the Marshall Field Bill." Some believed (1) Mr. Field was operating his liberal newspapers, PM and the Chicago Sun, as a sole proprietorship and, (2) because they were both thought to be losing money at that time, the Federal Government was in a sense "financing" these publications out of taxes Mr. Field would otherwise have had to pay. The Act was intended to limit the ability of wealthy individuals with multiple sources of income to apply losses incurred in "side-line" diversions to reduce their overall tax liabilities. The first "hobby loss" provision in the I.R.C. was enacted by the Revenue Act of 1943.
The I.R.C. was last modified for this issue in 1988, as I.R.C. § 1835 (Activities not engaged in for profit). Current I.R.C. § 183 provides a presumption that an activity is engaged in for profit if the activity is profitable for 3 years of a consecutive 5-year period or 2 years of a consecutive 7-year period for activities that consist of breeding, showing, training, or racing horses. Treasury Regulation § 1.183-16 sets forth the following nonexclusive list of nine factors to guide courts in analyzing a taxpayer's profit objective:
(1) The manner in which the taxpayer carries on the activity.
(2) The expertise of the taxpayer or his (or her) advisers.
(3) The time and effort expended by the taxpayer in carrying on the activity.
(4) The expectation that the assets used in the activity may appreciate in value.
(5) The success of the taxpayer in carrying on other similar or dissimilar activities.
(6) The taxpayer's history of income or losses with respect to the activity.
(7) The amount of occasional profits, if any, that are earned.
(8) The financial status of the taxpayer.
(9) The elements of personal pleasure or recreation involved in the activity.
However, the mere fact that the number of factors indicating the lack of a profit objective exceeds the number indicating the presence of a profit objective (or vice versa) is not conclusive.
This review was performed at the Internal Revenue Service (IRS) National Headquarters in Washington, D.C., in the Small Business/Self-Employed (SB/SE) Division, the SB/SE Division Campus7 Compliance Services function in Florence, Kentucky, and the Office of Appeals, Technical Services, Tax Policy function in Dallas, Texas, during the period October 2006 through June 2007. The audit was conducted in accordance with Government Auditing Standards. Detailed information on our audit objective, scope, and methodology is presented in Appendix I. Major contributors to the report are listed in Appendix II.
Results of Review
The Internal Revenue Service Is Aware That Problems Exist With Taxpayers Claiming Schedule C Losses From Not-for-Profit Activities
A number of taxpayers who have significant income from other sources reduce their taxable incomes by reporting losses on a U.S. Individual Income Tax Return (Forms 1040) Profit or Loss From Business (Schedule C). According to IRS estimates, incorrect deductions of hobby expenses account for a portion of the overstated adjustments, deductions, exemptions, and credits that result in about $30 billion per year in unpaid taxes.
The IRS has made several different efforts to administrate the tax law. First, as part of the SB/SE Division Tax Gap8 - National Research Project Communication Plan, on April 25, 2007, the IRS issued on its web site (IRS.gov) a Factsheet reminding taxpayers to follow appropriate guidelines when determining whether an activity is a business or a hobby (an activity not engaged in for profit). In general, if a taxpayer has hobby income and expenses, the expense deductions should be limited to the hobby income amount. The Factsheet detailed the nine factors to be considered when making this determination and the limitations for deducting some expenses from not-for-profit activities as itemized deductions on Form 1040 Itemized Deductions (Schedule A). In addition to the general public, the Factsheet's targeted audience included practitioner and industry groups.
Second, in 2005, the SB/SE Division Research function performed a research project on home-based businesses that included a review of Schedule C expenses to identify alternate treatments of potentially noncompliant behavior that would save audit resources. The Research function sent letters to taxpayers with potentially tax-abusive, home-based businesses in an attempt to change their potentially noncompliant tax behavior. Although some taxpayers did file amended returns, the overall response rate was low, and the SB/SE Research function concluded that the use of letters would not necessarily be productive as a tool to induce self-correction by home-based business participants.
In a third effort, in 2003, the IRS performed limited testing to determine if examinations of tax returns with Schedule C losses from potentially not-for-profit activities could be accomplished through correspondence examinations.9 In general, a correspondence examination does not include an examination of a taxpayer's books and records. The testing included 148 returns for which 103 taxpayers' Schedule C losses10 were disallowed because they were considered hobby expenses. These taxpayers were assessed taxes and interest of $372,089. The IRS has collected $345,600 from 95 (92 percent) of these taxpayers.11
As a follow-up to the IRS effort, we reviewed the accounts of the 95 taxpayers who had paid their assessments, to determine whether Schedule C losses were claimed on returns filed subsequent to the correspondence examinations. The results showed 48 (51 percent) of the 95 taxpayers continued to claim these losses in the succeeding tax years. Based on the test results, the IRS Campus Compliance Services function believes working the hobby loss issue through correspondence examination is not productive because the multiple contacts with taxpayers increased the amount of time needed to complete the examinations. While identifying potential hobby losses is part of the tax return examination classification process, the number of taxpayers taking multiple, consecutive year losses presents significant challenges to tax administration.
The Internal Revenue Code and Treasury Regulations Make It Difficult to Determine When a Schedule C Loss Is Related to a Business or Hobby
Two conditions exist to make I.R.C. §183 a challenge to tax administration. First, I.R.C. §183, also referred to as the hobby loss provision, and related Treasury Regulation §1.183-1 do not establish specific criteria for the IRS to use to determine whether a Schedule C loss is a legitimate business expense without conducting a full examination of an individual's books and records. The I.R.C. and Treasury Regulation do not require a taxpayer to have a reasonable expectation of profit; rather, the taxpayer needs just the "objective" of making a profit. Therefore, all facts and circumstances need to be considered in each case. In determining whether a profit objective exists, courts have ruled it may be sufficient that there is a small chance of making a profit. For example, an inventor may incur very substantial expenses in a venture for a profit even though the expectation of profit might be considered unreasonable. Additionally, the IRS, not the taxpayer, bears the burden to rebut the presumption that an activity was not a for-profit business.
Second, the law also allows taxpayers to justify a substantial Schedule C loss by claiming a minimal profit. For example, an activity could be considered a for-profit business if a taxpayer shows any profit during a 5-year period, even though much larger losses are claimed in the other taxable years. This allows taxpayers to break the cycle of having continuous years of losses and gives the appearance of being a for-profit business.
To identify the scope of the problem, we performed an analysis of Tax Year 2005 Form 1040 Schedules C showing no profits, only losses, over consecutive Tax Years 2002 - 2005 (4 years). We identified a universe of 1,483,246 taxpayers,12 many with significant income from other sources, that met this criterion; 1,076,796 (73 percent) of these individuals had their tax returns prepared by tax practitioners. Based on their Tax Year 2005 income levels, 1,203,175 of the universe of taxpayers potentially13 avoided paying $2.8 billion in income taxes (see Appendix IV for additional information).
14 The Individual Return Transaction File contains data transcribed from initial input of the original individual tax returns during return processing. Subsequent or amended return data are not contained in the File.
As previously noted, the purpose of the hobby loss provision was to limit the ability of wealthy individuals with multiple sources of income to apply losses incurred in "side-line" diversions to reduce their overall tax liabilities. Figure 1 shows 332,615 high-income15 taxpayers received the greatest benefit by potentially avoiding approximately $1.9 billion in taxes for Tax Year 2005. We also computed their expense-to-income ratios. Figure 2 shows almost 70,000 of the high-income taxpayers claimed expenses 5 times greater than their revenues.
We also analyzed how close the taxpayers were to making a profit by the fourth year. Figure 3 shows 204,015 high-income taxpayers reported either no gross receipts or expenses that were at least 2 times higher than their gross receipts, which allowed them to avoid paying potential taxes of more than $1.1 billion.
To further determine how well the IRS can actually administrate this provision through examinations, we analyzed IRS Audit Information Management System16 data and found 73,431 of the 1,483,246 taxpayers have either open or closed examination records for the 4-year period (2002 - 2005). The closed records resulted in assessments of about $345 million, which is only 12 percent of the $2.8 billion in potential tax avoidance for Tax Year 2005 alone.17 However, we were unable to determine the issue for which these taxpayers were examined. Consequently, the taxpayers' Schedule C losses may not be the reason for the tax assessments.
The challenges to tax administration caused by I.R.C. § 183 can be traced back to the legislative process. During the legislative process, the original intent of the hobby loss provision evolved into the existing I.R.C., which does not clearly establish when an activity is a business or a not-for-profit activity.
In February 1969, the House of Representatives Ways and Means Committee proposed a change to the hobby loss provision that would disallow the deduction of losses arising from a "business" that had not been operated with a reasonable expectation of realizing a profit from it. If an individual carried on an activity with a loss in excess of $25,000 in 3 years out of 5 consecutive years, it would be deemed that (unless shown to the contrary by the taxpayer) the taxpayer was not operating the activity with a reasonable expectation of realizing a profit from it.
However, the Senate Finance Committee substituted a different hobby loss provision and recommended the term "profit" be specifically defined to include not only immediate economic profit but also any reasonably anticipated long-term increase in the value of property. In making the determination of whether an activity is not engaged in for profit, the Senate Finance Committee intended that an objective rather than a subjective approach should be used. A reasonable expectation of profit was not required, and the facts and circumstances would have to indicate that the taxpayer entered the activity, or continued the activity, with the objective of making a profit. The Senate Finance Committee recommended the IRS bear the burden for rebutting this presumption, not the taxpayer as proposed by the House bill.
In addition, the final Treasury Regulation § 1.183-1 (issued in July 1972) did not clearly establish when an activity is a business or not-for-profit activity. The Treasury Regulation established nine factors that should be taken into account when determining if an activity is engaged in for profit. However, the factors are a guide to assist in making the determination; they do not establish a clear standard.
A study conducted in September 1998 by the Joint Economic Committee18 defined a "good tax" as:
Ÿ Not costly for either the Federal Government or taxpayers to calculate or administer; on the other hand, tax avoidance is difficult and risky.
Ÿ Neutral in its impact on resource allocation decisions, minimizing negative effects on economic growth; it does not lead to unproductive economic activity that is tax induced.
Ÿ Fair; people believe the tax burden is equitably distributed among the taxpaying population.
When comparing the criteria for a good tax to what is stated in I.R.C. § 183, we conclude that it is difficult for the IRS to efficiently and effectively administer this provision. The tax law cannot be efficiently administrated when examination resources would be required to determine compliance. Additionally, taxpayers may be abusing the law by taking multiple, consecutive year losses for expenses that could be for personal use to reduce taxes on other incomes.
Recommendations
Recommendation 1: The Commissioner, SB/SE Division, should provide a copy of this report to the Department of the Treasury, Office of the Assistant Secretary for Tax Policy, to consider proposal of legislative changes to I.R.C. § 183. The proposal should include establishing a clearly defined standard or bright-line rule19 for determining whether an activity is a business or not-for-profit activity. Management's Response: The Commissioner, SB/SE Division, agreed with the recommendation. Upon receipt of the final report, the Director, Communications, Liaison, and Disclosure, will coordinate with the Office of Legislative Affairs to forward a copy to the Department of the Treasury Office of Tax Policy.
Recommendation 2: Aside from a legislative remedy, due to the large number of tax returns with Schedule C losses being prepared by tax practitioners, the Director, Communications, Liaison, and Disclosure, SB/SE Division, should continue to coordinate with practitioner organizations to encourage compliance with existing provisions. Management's Response: The Commissioner, SB/SE Division, agreed with the recommendation, stating that the Division's education and outreach activities should include key messages regarding current provisions of I.R.C. § 183 to further supplement the April 2007 Hobby Loss Factsheet. Management will include key messages and talking points about I.R.C. § 183 tax obligations as a Fiscal Year 2008 outreach initiative directed to practitioner organizations.
Presented by Alvin Brown and Associates,
tax attorney, formerly with the Office of the Chief Counsel of the
IRS.
Call us for all IRS tax issues, problems and emergencies
Protect yourself from IRS intimidation, errors, and penalties.
www.irstaxattorney.com- ab@irstaxattorney.com -
(888)
712-7690 - (703) 425-1400