OPPORTUNITIES EXIST TO IDENTIFY AND EXAMINE INDIVIDUAL TAXPAYERS WHO DEDUCT POTENTIAL HOBBY LOSSES TO OFFSET OTHER INCOME
Final Report issued on April 12, 2016
Highlights of Reference Number: 2016-30-031 to the Internal Revenue Service Commissioner for the Small Business/Self-Employed Division.
IMPACT ON TAXPAYERS
Internal Revenue Code Section 183(a) generally disallows business tax deductions for activities “not engaged in for profit” and Section 183(d), also referred to as the “hobby loss” provision, provides a presumption that most activities are engaged in for profit if the activity is profitable for three years of a consecutive five-year period (two of seven for breeding, training, showing, or racing of horses). A September 2007 TIGTA report found that approximately 1.2 million taxpayers in Tax Year 2005 may have used hobby losses to reduce their taxable incomes to potentially avoid paying $2.8 billion in taxes. Identifying and auditing additional individual returns that improperly deduct hobby losses could help to reduce noncompliance in this area.
WHY TIGTA DID THE AUDIT
This audit was initiated as a follow-up to the September 2007 TIGTA report to determine whether the IRS was maximizing opportunities to identify the most significant Schedule C, Profit or Loss From Business, noncompliance. The overall objective of this review was to determine whether the IRS is taking sufficient action to minimize improper Schedule C losses claimed by taxpayers and the resulting loss of revenue to the Government.
WHAT TIGTA FOUND
TIGTA found that the IRS can improve its methods of addressing taxpayers who offset their income with hobby losses. Specifically, IRS methods for identifying high-income taxpayers who may be offsetting their income with hobby losses do not maximize the use of all relevant taxpayer information available to the IRS, and when returns containing potential hobby losses are selected for audit, the examiners do not always address the hobby loss issues.
TIGTA’s evaluation of IRS data from Processing Years 2011 through 2014 identified 9,699 individual returns from Tax Year 2013 that claimed a Schedule C loss of at least $20,000, gross receipts of $20,000 or less, and reported wages of at least $100,000. The taxpayers also reported losses in four consecutive years (Tax Years 2010 to 2013). TIGTA’s review of a statistically valid sample of 100 returns determined that 88 returns (88 percent) showed an indication that the Schedule C businesses were not engaged in for profit. TIGTA estimates that 7,511 returns in the total sample population of taxpayers may have inappropriately used hobby loss expenses to reduce taxes by as much as $70.9 million for Tax Year 2013.
WHAT TIGTA RECOMMENDED
TIGTA recommended that the IRS: 1) make use of SB/SE Division research capabilities to identify high-income individual returns with multiyear Schedule C losses and other factors that indicate the taxpayer may not have a profit or capital gain motive for the activity and 2) emphasize the importance of required filing checks in the preliminary determination of whether to pursue a hobby loss issue and provide tools to assist examiners in documenting their conclusion.
In response to the report, IRS management agreed with our recommendations and plans to take corrective actions.
READ THE FULL REPORT
To view the report, including the scope, methodology, and full IRS response, go to:
Phone Number / 202-622-6500
E-mail Address / TIGTACommunications@tigta.treas.gov
Website / https://www.treasury.gov/tigta