Is it a “Hobby” or “Business”?
Part 3
July 22, 2004
By Jim Harnsberger, Sr. Tax Analyst

SAN DIEGO – The Second and Third test to be applied in the determination of “profit motive” is one in which many business owners fail to recognize the importance of clearly defined operational methods or requirements imposed by the code.

Tax professionals very often are ill-prepared to handle these issues when questioned by the IRS auditor; and attorneys very often fail to advise the clients about some of the important aspects of protecting the corporate shield in operating the business activity. The IRS will dissolve the corporation for tax purposes if in the analysis, it determines that the taxpayer fails to meet these important standards; thus creating a tax nightmare for the business owner. At best a corporation could lose its tax protections and the business owner would be taxed as if they were self-employed if certain operational considerations are not implemented in the business.

2. Expertise of Taxpayer and Advisers
Preparation for an activity by extensive study or consultation with experts may indicate a profit objective where the taxpayer conducts the activity in accordance with such study or advice. See sec. 1.183-2(b)(2), Income Tax Regs. A taxpayer need not make a formal market study before engaging in an activity but should undertake a basic investigation of the factors that would affect profit. Westbrook v. Commissioner , T.C. Memo. 1993-634, affd. 68 F.3d 868 (5th Cir. 1995). Expertise with respect to the mechanics of an activity can be distinguished from expertise in the economics of such activity, and the taxpayer's failure to obtain expertise in the economics of the activity in question may indicate a lack of profit objective. Burger v. Commissioner , 809 F.2d 355, 359 (7th Cir. 1987), affg. T.C. Memo. 1985-523. Any study or pre-business investigation will normally satisfy this test standard in an audit examination. Clearly documented writings, research materials, seminars, trips and meetings will demonstrate further investigative intent by the taxpayer, and these become business deductions.

3. Time and Effort Expended
The fact that the taxpayer devotes much of his or her personal time and effort to carrying on an activity, particularly if the activity does not have substantial personal or recreational aspects, may indicate a profit objective. Sec. 1.183-2(b)(3), Income Tax Regs. The fact that the taxpayer devotes a limited amount of time to an activity does not necessarily indicate a lack of profit motive where the taxpayer employs competent and qualified persons to carry on such activity.

It is worth noting that this test can be evaluated in numerous ways during an examination audit. What is most important in making this determination is to be able to demonstrate through some form of constructive evidence that the taxpayer participates in an active and material manner meaningful to the operations of the business. Daily logs, day-planners, errands, meetings with legal counsel or advisors all go to demonstrate an “active and material” role in the business activity.

San Diego based Tax Smart America has developed a unique business methods Intellectual Property patent that defines these legal standards for dozens of business types. Careful consideration of all points, the operational considerations, and counter-measures for audits make this unique approach very innovative in advising clients about the manner of conducting the business activities. You may reach the company at (619) 469-5800 for more information on their Business Methods