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Tricky issue spurs tax court ruling, IRS warning

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The Internal Revenue Service is stepping up efforts to prevent taxpayers from deducting losses on activities that aren't genuine businesses run to make a profit. The problem: It's not so easy to tell a budding business from a hobby.

Officials say new research shows taxpayer errors in this area are costing the government billions of dollars a year in unpaid taxes. Thus, auditors are "on the lookout" for people trying to deduct losses from hobbies, an IRS spokesman says. To underscore the agency's concern, the IRS recently issued a fact sheet the spokesman says is aimed at "making sure that taxpayers know and abide by the rules."

The fact sheet summarizes the law, which allows taxpayers to deduct "ordinary and necessary" expenses involved in a trade or business. Generally, an activity qualifies as a business if it is carried on "with the reasonable expectation of earning a profit," the IRS says. What makes this rule so important is that if an activity isn't truly designed to make a profit, you can't use losses from it to offset other income. (This rule applies to individuals, partnerships, estates, trusts and S corporations.)

However, the IRS' interpretation doesn't always prevail, as a recent court case illustrates. In a decision that is attracting close attention among lawyers and accountants, the U.S. Tax Court recently ruled in favor of Tracey L. Topping, a Florida woman who deducted net losses from her equestrian activities, which she said were part of her plan to develop a profitable interior-design business.

The decision is especially important because many people run more than one business, and there can be important connections between each of those businesses -- as in Topping's case. Moreover, the case underscores the importance of keeping good records and putting together "a compelling business strategy," says David Aughtry, an Atlanta lawyer at Chamberlain, Hrdlicka, White, Williams & Martin, who represented Topping.

But how are you supposed to figure out whether your activity qualifies as a genuine for-profit business? That can be exceptionally tricky. The IRS says you should consider several factors, such as: Does the time and effort put into the activity indicate you intend to make a profit? Do you and your advisers have the knowledge needed to carry on the activity as a successful business?

Another factor is whether you have made a profit in the past. The IRS says it "presumes" an activity is indeed carried on for profit if you have made a profit during at least three of the past five tax years, including the current year. (The rule is different -- at least two of the past seven years -- for activities that consist primarily of breeding, showing, training or racing horses.)

It is easy to misunderstand this profit test, says Frank Degen, an enrolled agent in Setauket, N.Y. Some activities that have lost money for many years still have qualified as a business intended to make a profit, Degen says.

To be sure, if an activity doesn't qualify as a for-profit business, you still may be able to deduct certain items. But you can deduct them only if you itemize and then only in "a certain sequence," and up to certain limits, says George Jones of CCH, a Wolters Kluwer unit that publishes tax and other business information.

The Topping case is especially interesting because Topping's lawyers persuaded the Tax Court that her equestrian and related activities were part of her strategy to build a design business -- and that the combination was conducted for profit.

Judge Joseph Goeke agreed with Topping's assertion that her plan was to use her prominence in the equestrian world to build an interior-design business involving homes and high-end horse barns. He also concluded that the expenses associated with her equestrian activities were "ordinary, necessary and reasonable in amount."

The judge sided with Topping even though the IRS cited a few other cases in which the Tax Court had ruled that a taxpayer's multiple activities couldn't be lumped together. For example, the court refused to combine a taxpayer's farming/polo activity and his real-estate law practice, despite the taxpayer's argument that one reason he began playing polo was to meet clients for his law firm.

Judge Goeke said those cases weren't analogous to the Topping situation. The judge agreed there was a "close organizational and economic relationship" between the equestrian and design ventures.

The IRS declined to comment on whether it plans to appeal the decision. The IRS fact sheet can be found on the IRS Web site (www.irs.gov). Type "FS-2007-18" in the search box.

Whatever the case, pay close attention to record keeping. "The taxpayer should not commit a foot-fault by failing to engage in the dull and time-consuming task of keeping business books and records," warns Donald Alexander, a former IRS commissioner and now a Washington lawyer at Akin Gump. "Many fail this basic and elementary requirement."

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