It has been a rough year for many businesses.
Congress has tried to help with economic stimulus measures. Help who? Help a business that is losing right now. And it’s not their fault.
In general, winning impresses Americans. We don’t invite the losing Super Bowl team to the White House. The losing quarterback does not announce, “I’m going to Disneyland!” The athlete who failed to win a gold medal is not on the Wheaties box.
We also design our tax laws for winning. A particular provision of the law, specifically “Section 183,” denies tax losses for activities “not engaged in for-profit.”
Because we Americans cannot fathom running a business without an intent to profit, Section 183 has been colloquially named the “hobby loss” rule. That is, we assume that it must apply only to hobbies. For all else, winning must be assumed paramount to an American.
Developing a tax policy requires adopting a value system. For those who value winning, there cannot be tax subsidies for losing. Penalizing losing can extend beyond just hobbies. Section 183 paints with a broad brush.
To be able to deduct losses from an activity, the owner must be able to show an intent to profit from that activity. Section 183 says that if you report a net profit in three of five years, you are presumed to meet this profit intent.
The law also says that those who fail to make a profit for three of five years are not presumed to lack a profit-making intent. The IRS has often ignored this part of the rule. IRS often says – no tax loss allowed without a profit in three of the last five years.
The IRS’ bias can be explained by a desire to protect federal revenues. It can also be part of our American bias – you didn’t make a profit in three of five years? That must have been by design.
Section 183 applies to much more than hobbies. It can also apply where the taxpayer has experienced losses and doesn’t change what they are doing. They don’t seek advice. They don’t change operations. They don’t run the activity “like a business.”
Different people can interpret things the owner might be asked to show as proof of a profit-making intent in different ways. A tax adviser is likely to look for three profitable years in the last five to avoid the subjectivity of Section 183.
I have handled about a half dozen Section 183 audits in the past 10 years. I “won” all of them. No need for quotes you say, we all know what won means.
Maybe not. If the win takes significant time, and causes the business owner to bear significant costs, it may not look or feel like a win when the finish line is crossed.
When a politician or celebrity is charged with a crime, their costly defense attorney generally says, “My client looks forward to the chance to prove his innocence in court.”
No. No one “looks forward” to going to court to prove innocence. They would much prefer that the charges never be filed.
Therefore, business owners join their tax advisers in trying to meet that three-of-five presumption. Even a small profit in three years creates a show of strength to keep the IRS from picking a fight.
COVID 19-20-21 has cut Samson’s business hair. The strength used to create three years of profits has been sapped. And it’s not their fault.
The many pro-business tax provisions enacted in COVID world are helpful. However, for many businesses, the help had not been enough. For some of those, Section 183 may be a business pandemic.
Remember that Section 183 usually requires a showing that the owner tried to change things to turn a loss to a profit. But for COVID losses, it’s not your fault. You can’t drive out the pandemic.
So here’s a thought. IRS should issue a Revenue Procedure that suspends 2020 and 2021 from use in the three-year profit test. They don’t need a law – a procedure just says this is the way we will measure the test. It could even be a Notice. Just promise us you won’t hold pandemic loss years against us.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at email@example.com.