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To get a sense of tax appeals, let’s consider the following scenario:
Mick was a telephone company executive by day and a rock band leader Saturday nights. Four years back he formed the Boohoos. The group never made it to the big time, but Mick enjoyed performing. Bonuses at the phone company allowed Mick to buy new sound gear and a Ford van to haul it to gigs.
He became more enthusiastic about his music and hired an agent for the Boohoos. Mick tax-reported his musical income and expenses on his tax returns as a sideline business. The music venture showed overall losses, which were claimed to offset Mick’s income from his regular job on his tax returns. His total tax bill was lowered.
Is there a tax problem lurking for Mick?
The law says that a sideline business loss can produce a tax write-off for Mick as long as he is honestly trying to make a profit. The tax code provides a test for profit motive:
If a venture doesn’t make money in at least three of five years, it is presumed to be a hobby, and not operated for profit. Hobby losses are personal and cannot be claimed for tax purposes. While this three-of-five-years legal presumption is not final, it puts the burden on Mick to show he was trying to make a profit. As it turned out, Mick had made a small profit in two of the last four years he had been tax-reporting his musical activities.
The hobby loss issue would never arise unless Mick was audited, and, of course, he was. IRS audit classifiers are on the lookout for loss claims that offset income from another job—in effect, a tax shelter. The IRS hunts tax shelters like wolves pursue sheep. When an auditor finds an operation wasn’t run to make a profit, he disallows all expenses in excess of income.
If Peggy Sue’s ScamWay distributorship brought in $1,000 and she deducted $3,000 in expenses, the IRS could disallow her $2,000 tax loss.
Unless the IRS was convinced that Peggy Sue was serious about making a profit. The IRS frequently finds the real motive in home sales enterprises is social—entertaining friends and getting home products for personal use. Dabbling in a side business doesn’t cut it.
Back to Mick.
During the year under audit, Mick’s music income was only $1,300, but he claimed $12,300 in business expenses. His largest expenses were the new van and sound system. Under the hobby loss rules, the auditor decided Mick’s music expenses were primarily for his personal pleasure. He disallowed the $11,000 tax loss. This meant added taxes, penalties, and interest of about $4,500. To make matters worse, he then recommended an audit of two more years.
Mick argued that he had worked hard to make a musical career. Recently he had been getting more jobs for the Boohoos; one hit record would make him millions and the IRS plenty of taxes. The auditor, apparently not a rock fan, was unmoved. An informal appeal—a meeting with Mick and the auditor’s manager—went nowhere.
Next, Mick received the examination report and appeal notice. He filed his protest letter within the 30-day deadline. Mick felt strongly he had been trying to make money in music, even though he had failed so far. Mick’s task was to show the appeals officer a justification for changing the audit result.
The auditor disallowed Mick’s deduction of his music equipment as a business loss. His report said that the business expense was not established. Mick called the auditor to ask what tax code section he relied on to reach his decision. The answer was Internal Revenue Code § 183.
Online you can find some simple reference sources at sites such as TurboTax.com. After doing a keyword search for “IRC 183 and losses,” Mick found a definition of a business as “a pursuit or occupation carried on for profit, whether or not profit actually results.” There was an excerpt from a tax court case stating “an activity may be for profit although the investment is not expected to generate profits for several years under the current level of activity.”
So, the legal principle in Mick’s favor is that the profit motive, not the actual result, distinguishes a business from a hobby. The intention to make a profit is sufficient under the tax law, even if the probability of financial success is small or remote. This meant that Mick’s musical activities were not automatically disqualified as a business just because he lost money. Mick photocopied the following pages.
Mick found more help in . The index lists “Hobby as a Sideline Business,” which leads to the following:
“If you show a profit in three or more years, the law presumes you are in an activity for profit. The presumption does not necessarily mean that losses will be automatically allowed; the IRS may rebut the presumption.”
This looked significant because it cited tax code § 183, the one on which the auditor based his decision. Mick made another photocopy.
In the first two years Mick claimed his music business, he was using his old equipment. He didn’t deduct any vehicle expense. The result was that in year one he showed a profit of $120 and in year two he showed a profit of $332. In year three—the audit year—Mick bought the van and the new equipment, causing sizable losses in years three and four. The appeals hearing took place in year five, for which a tax return was not yet due.
So Mick can’t be helped by the tax code’s “three-of-five-year” presumption of profit rule. Mick had only two profitable years out of four. If his appeal hearing were held after he filed a tax return for year five then maybe it would be different. The trick would be to prepare the latest tax return to show a profit—by not taking some expense deductions. This would be perfectly legal, as the law requires you only to report all your income; you are never forced to claim a deduction.
Mick could go into the hearing with the benefit of the three-year presumption of profit rule. This would put him in a stronger position for the “profit motive” component, but alone wouldn’t assure him an outright win. He still might have to convince the appeals officer that he operated the venture in a businesslike manner.
After Mick filed his protest requesting an appeal, the IRS notified him of a conference date. Mick and an appeals officer met. Mick outlined his position. He showed a contract from a talent booking agent who had gotten the Boohoos one job. Mick presented a flyer and event calendar showing the group had performed at public events twice during the audited year. He didn’t mention that one appearance was at an unpaid charity benefit. Mick showed a publicity photo and his calendar showing band rehearsal dates.
Mick understood that appeals are rarely 100% successful. He also didn’t want to lose any more time from work and his life by going on to court. His goal was to give the officer justification for compromising, not to walk away clean. In a half hour, Mick finished presenting his case and said, “Let’s settle this without going to court. I’ll accept a 20% disallowance of my music business losses.” Mick was offering to let the IRS reduce his losses from the $11,000 adjustment the auditor made, to $2,200.
The appeals officer replied that he was thinking a 50% disallowance, from $11,000 to $5,500. Mick was in! The IRS accepted the possibility that a court might find that Mick was trying to make a profit. They took a coffee break. On resuming, Mick commented on the photo of the Little Leaguer on the officer’s desk. Mick said he had a son, and they talked about parenthood for a few minutes. The appeals officer seemed relieved not to talk taxes for a bit.
At 4:30, near IRS quitting time, Mick said that he’d agree to split the difference and accept a 35% disallowance, from $11,000 to $3,850 of his losses and no penalties. Mick also requested the appeals officer not recommend the other two years be opened for audit. The officer agreed. While this was no guarantee of no more audits—appeals officers don’t have this authority—their words carry great weight. Several weeks later, Mick received the settlement letter.
Mick’s case is typical of how IRS appeals are handled—and settled. If Mick hadn’t appealed, he would have owed $11,000 and would have been audited for two other years. Mick’s appeal didn’t require great tax expertise. It did involve some effort in research and four or five hours of preparation and attendance at the hearing. Most appeals—be they home office deductions, entertainment expenses, business auto usage, or whatever—can be handled successfully like Mick’s.
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