Last 
month we blogged about potential issues with short-term rentals and Section 183. Section 183 is part of the tax law that says you cannot deduct expenses of activities you’re not engaging in for profit.
But that blog post got me thinking about the Section 183 Schedule C problem. Which is similar.
But before we dig into the details, let’s discuss briefly what Schedule C is. And then I’ll move on to discussing the Section 183 connection to Schedule C.
What is Schedule C?
Schedule C is a profit and loss schedule that is filed on the individual level to report business income. When you file Schedule C, you are telling the IRS you “engaged in an activity for profit.” An activity must be “engaged in for profit” in order to be considered a business.
Positive net income from Schedule C is ordinary income subject to self-employment and income tax. Negative net income from Schedule C offsets, or reduces, your other ordinary income. It also reduces the income taxes you pay.
What is the Section 183 Schedule C problem? Many of the Schedule C losses filed every year with the IRS do not rise to the level of an activity engaged in for profit. The activities, in other words, are hobbies. You do not want to report a loss from a hobby, receive a tax benefit, and end up under examination with the IRS.
If you are unsure whether your activity is a hobby or a business, the IRS lays out nine factors to help you decide. These factors will help clarify whether you operate an “engaged in for profit” business or a hobby. Whether you have a Section 183 Schedule C problem.
Let’s take a closer look at each factor.
1. Manner in Which a Taxpayer Carries on the Activity
This is the first factor detailed in the Section 183 Audit Technique Guide, and unsurprisingly, is very important. You want to operate your activity in a business like manner. Here are several business-y things you ought to consider implementing if you are not doing so already:
- Separate personal and business finances. Use a dedicated business checking account and credit cards.
- Use a real accounting system to track your income and expenses.
- Write a business plan to show, specifically, how your business will make a profit.
- If your business is not making a profit, change your operating methods to reach profitability.
- Register your business and pay appropriate state level taxes and file all appropriate forms.
Again, running your activity like a legitimate business is very important to support the engaged in for profit intent. An activity run like a hobby, is probably a hobby.
2. Expertise of the Taxpayer or Their Advisors
You want to be an expert in your activity or listen to or hire experts that are. This doesn’t mean you need a Ph.D. or master’s degree, but you need to have knowledge of your activity and industry.
This makes intuitive sense. It would be impossible (or nearly) to make a profit operating an activity, or operating in an industry, you know nothing about.
Substantiate the steps you took to acquire knowledge. It might be reading books written by experts. Or taking seminars or classes. Maybe you really went to school and earned a Ph.D..
Relying on (and probably paying for) advice from experts like CPAs, attorneys, and consultants also help support your activity qualifying as an engaged in for profit business.
3. Time and Effort Expended in the Activity
The time expended in the activity should be consistent with an intent to make a profit. This is vague because there is no bright-line “time” test. And time doesn’t need to be exclusive or significant if competent management or employees are hired.
An examiner will look at the total time spent in the activity, plus time the taxpayer spends in other business activities and employment when weighing this factor.
The point is you want good documentation of time spent on the activity, whether it is you or someone else doing the work. The more time spent, the greater chance of your activity qualifying as an engaged in for profit business.
4. Expectation Assets Used in Activity May Appreciate in Value
The title sounds self explanatory but there is a bit of nuance. Appreciating assets, like property used in rental real estate, help to qualify an activity as an engaged in for profit business.
The nuance? The IRS is okay with your activity realizing losses year after year, as long as there is the expectation that, eventually, the activity pays off and generates positive income. The regulations even indicate a “reasonable expectation of profit is not required.”
I mentioned real estate earlier; this is also common in intellectual property. The goal is to hold the asset long enough to realize substantial appreciation.
In an examination, you want to point to supporting documents like appraisals or comparables. Something that helps substantiate the appreciation in value.
Note: Different rules apply for farming, as discussed a bit later
5. Success of Taxpayer in Carrying on Other Similar or Dissimilar Activities
A history of successful entrepreneurship helps to qualify your activity as an engaged for profit business. I think a history of unsuccessful entrepreneurship helps support this too. Not every business venture ends up being profitable.
If your activity isn’t doing well? Course correct and change things up to try and make it successful. And document the changes you make.
6. Taxpayer’s History of Income or Losses with Respect to the Activity
I’m going to paraphrase the regulations here. They say, basically, that losses during the start-up stage of an activity may not necessarily indicate the activity is not engaged in for profit. But, continued losses beyond the start-up stage, if not explainable, may indicate the activity is not being engaged in for profit.
If your activity is losing money year after year, you want to explain why. Market conditions, disease, theft, natural disaster, fire, etc. are all good explanations of why a business might not be profitable.
7. Amount of any Occasional Profits that are Earned
Section 183 gives a taxpayer a presumption of profit intent if gross income from an activity exceeds the deductions from the activity for at least three out of five taxable years. Most new activities will struggle to meet this.
As I said above, the expectation of profit is not required for your activity to be considered an engaged in for profit business. And occasional profits, especially in highly speculative ventures, indicate the activity is engaged in for profit.
You absolutely should not manipulate income or expense numbers to artificially show a profit to meet the safe harbor (more on the safe harbor below). An IRS examiner will almost surely catch this.
An IRS examiner will compare income and expenses between periods to find deviations. They will also substantiate the income and expenses reported on the tax return. Phantom income, or reduced or non-reported expenses, will be easy for an examiner to find.
8. Financial Status of the Taxpayer
A lack of income or capital from other sources indicates an activity is an engaged in for profit business. If your Schedule C activity is your only source of income, most likely you have an engaged in for profit business and not a hobby.
If you have other major sources of ordinary income, you want to carefully go through each of these factors to determine how to accurately report your activity on your tax return.
9. Elements of Personal Pleasure
We have reached the final factor, and this one is quite subjective. What is pleasurable to one person might be a chore for someone else.
You want to minimize the amount of personal pleasure in your activity as much as possible. Let me explain.
An activity will not be treated as not engaged in for profit merely because the taxpayer has motivations other than solely making profits. There will always be other activities which yield higher returns. And those activities might make you miserable. There should be a balance of enjoyment and financial success, not a narrow focus on one or the other.
There are a handful of other points I want to discuss before we wrap up.
Farming Activities
This blog post is tailored for Schedule C activities, but Section 183 is particularly consequential for farming activities that are reported on Schedule F. Section 183’s intent is to prevent taxpayer’s engaged in farming activities from offsetting farming losses with land appreciation.
Remember factor 4? It doesn’t apply here, at least with land. The regulations say the farming and holding the land for appreciation constitute one activity, but only if the farming activity reduces the net cost of carrying the land. In other words, the farming itself needs to be profitable. Land appreciation has no weight in the determination of a farming activity being an engaged in for profit business.
Safe Harbor
Most of Section 183 is subjective, requiring taxpayers and examiners to look at the facts and circumstances of each activity. But, fortunately, there is one quantitative way of determining if your activity rises to the level of an engaged in for profit business.
There is a presumption an activity is engaged in for profit if:
- The activity has net profits for three out of five consecutive tax years, or
- In the case of breeding, training, showing or racing horses, the activity has net profits for two out of seven consecutive tax years.
The IRS can still dispute your activity is really a hobby and not a business, but the burden rests on the IRS to prove it.
This safe harbor is difficult to meet for business that are still in their “start up” phase. Fortunately, there is a an election to postpone the determination, which I cover next.
Election to Postpone Determination
Form 5213, Election to Postpone Determination, can be filed to delay an IRS determination as to whether an activity is engaged in for profit. You can find the form here.
You want to file this form in the first year or two after beginning your activity if you expect to realize losses. When filed, the IRS will postpone their determination until after the end of the 4th consecutive tax year, or 6th year if your activity is farming.
The form must be filed within three years of the due date of the first tax return. If you receive a Statutory Notice of Deficiency from the IRS (the notice disallows hobby loss deductions) you must file within 60 days.
Final Thoughts on the Section 183 Schedule C Problem
The IRS estimates roughly 70-80% of Schedule C filers with losses are really hobbies. This means Schedule C’s with losses are exceptionally vulnerable to IRS examinations.
You want to be confident your activity rises to the level of “engaged in for profit” before you claim a Schedule C loss. And be ready to defend your position with the IRS. If you are unsure after reading this, you may consider reaching out to a tax professional for help.