Accounting Adjusted Gross Income and Taxable Income Questions

For this assignment:

Find and prepare PDF versions of the following IRS forms and Schedules, if applicable: Schedule C, Schedule E, Schedule SE, Schedule 1, and Schedule 2; andForm 1040 (page 1 only). Statement of FactsTaxpayer Jane Doe has the following personal information:Name: Jane DoeSSN: 444-44-4444Address: 555 Any Street, Anytown, CA 90000Marital Status: SingleMinor Children: 0Elections: Standard deductionSummary:Jane Doe (DOE) is self-employed as an advertiser (cash basis financial details below).  Additionally, DOE rents out a room in her house on Airbnb (financial details below). DOE purchased her principle residence for $600,000 in 2020. Prior to the current tax year, DOE loaned her sister $10,000. During the current tax year, DOE’s sister filed for bankruptcy and received a full discharge of all her debts. DOE also had the following financial activity:Advertising Business Financials:EIN: 55-5555555DBA: Your Name HereAddress: 112 Corp. Blvd. Ste 100, Anytown, CA 90000Payments received from clients: $75,000Payments made for her business:$5,500 office supplies;$6,000 in client related travel;$4,000 in accounting and legal fees;$12,000 in office rent;$4,000 in utilities; and$250 for ten gift baskets for ten clients.Rental Business Financials:Days rented: 10Rents received per day: $500Payments made for her rental:$500 cleaning costs;$200 in utilities;$100 in accounting fees;$1,000 in bedding purchases; and$100 in food and other items for guests.For simplicity, please ignore any possible QBI deductions.Answer the following questions according the above statement of facts:1. The total amount that transfers to the front page of Form 1040 from Schedule D is: 0 (10,000) (3,000)2. The total self-employment tax on Schedule SE and the total amounts on Schedules 1 and 2 are:A. $3,056 / $6,111 / $3,056 B. $6,617 / $3,309 / $6,617 C. $6,111 / $3,056 / $6,111 D. $3,309 / $6,617 / $6,6173. Total Income on Form 1040 is:$43,250 $40,250 $33,2504. Adjusted Gross Income (AGI) and Taxable Income on Form 1040 are:A. $37,194 and $24,244 B. $30,194 and $27,700 C. $31,794 and $27,700 Office of Chief Counsel
Internal Revenue Service
Memorandum
Number: 200524001
Release Date: 6/17/2005
CC:TEGE:EB:HW:BPie
GL-125239-04
UILC:
162.35-00
date:
05/17/2005
to:
from:
subject:
Associate Area Counsel, CC:SB/SE:SF
Attention: Anthony Kim
Branch Chief, CC:TEGE:EB:HW
Health Insurance Deduction for Self-Employed Individuals Under I.R.C. § 162(l)1
This Chief Counsel Advice responds to your request for assistance dated March 18,
2005 regarding I.R.C. ‘ 162(l). In accordance with I.R.C. ‘ 6110(k)(3), this advice may
not be used or cited as precedent.
ISSUES
1. Whether a self-employed individual who is a sole proprietor may deduct,
pursuant to I.R.C. § 162(l), insurance costs for the medical care of the sole
proprietor and his or her spouse and dependents from the earned income
derived from his or her trade or business when the health insurance policy
purchased by the sole proprietor is issued in his or her individual name and not in
the name of the sole proprietor’s trade or business.
2. Whether a self-employed individual may aggregate the profits and losses of two
or more businesses to establish the net income ceiling up to which he or she
may claim insurance costs deductions under I.R.C. § 162(l).
CONCLUSIONS
1
Section 162(l) was originally enacted as section 162(m). It was redesignated as section 162(l) by
section 301(b)(3) of the Miscellaneous Revenue Act of 1988. This document refers to the section as
section 162(l) both before and after the redesignation.
1. Yes. A self-employed individual who is a sole proprietor may deduct the medical
care insurance costs of the sole proprietor and his or her family from the earned
income of his or her trade or business when the health insurance policy
purchased by the sole proprietor is issued in his or her individual name and not in
the name of the sole proprietor’s trade or business.
2. No. Under I.R.C. § 162(l), the health insurance costs deductions must be
claimed for a specific plan providing medical care coverage that is established
under a specific trade or business and the deductions are limited to the earned
income of that specific trade or business.
DISCUSSION
I.R.C. § 162(l)(1)(A) allows an individual who is an employee within the meaning
of I.R.C. ‘ 401(c) to deduct amounts paid during the taxable year for insurance which
constitute medical care for the taxpayer and the taxpayer’s spouse and dependents.
I.R.C. ‘ 162(l)(2)(A) provides that no deduction is allowed to the extent that the
amount of the deduction exceeds the taxpayer’s earned income (within the meaning of
I.R.C. ‘ 401(c)) derived by the taxpayer from the trade or business with respect to
which the plan providing the medical care coverage is established. The deductible
amount has been limited in the past to certain percentages of the amount paid. But, for
the taxable year 2003 and thereafter, 100% of the amount paid is allowed up to the
earned income limit. I.R.C. § 162(l)(1)(B). The deduction is further limited in that no
deduction is allowed for costs during a month in which the taxpayer is eligible to
participate in any subsidized health plan maintained by any employer of the taxpayer or
of the spouse of the taxpayer. I.R.C. ‘ 162(l)(2)(B).
One of the reasons for enacting the ‘ 162(l) deduction was that the existing rules
relating to the exclusion from gross income for benefits under employer accident or
health plans created unfair distinctions between self-employed individuals and the
owners of corporations. Owners of corporations could exclude from gross income
health benefits provided by the corporation, whereas no similar exclusion was available
to self-employed individuals. See, S. Rep. No. 99-313, 99th Cong., 2d Sess. 666
(1986), 1986-3 (Vol. 3) C.B. 666. The legislative history contrasts the tax benefits
available to owners who are corporate employees with the lack of similar benefits for
self-employed individuals. Similarly, the deduction was increased in 1998 for taxable
years beginning after December 31, 1998 “in order to reduce the disparity of treatment
between insurance expenses of self-employed individuals and employer-provided
health insurance and to help make health insurance more affordable for self-employed
individuals.” H.R. Rep. No. 105-817, 105th Cong., 2d Sess. 55 (1998), 1998-4 C.B. 307
When I.R.C. ‘ 162(l) was enacted in 1986, ‘ 162(l)(2)(A) did not limit the
taxpayer’s earned income to one trade or business. The language “derived by the
taxpayer from the trade or business with respect to which the plan providing the medical
2
care coverage is established” was added by section 1011B(b)(3) of the Technical and
Miscellaneous Revenue Act of 1988, retroactive to the enactment of ‘ 162(l).
I.R.C. ‘ 162(l) also included a provision under which the ‘ 162(l) deduction was
not available to any taxpayer for any taxable year unless coverage was provided under
one or more plans meeting the requirements of section 89 (nondiscrimination
requirements), treating such coverage as an employer-provided benefit. This provision
was deleted in 1989 by section 203(a)(4) of Pub. L. No. 101-140, 1990-1 C.B. 207,
retroactive to the enactment of ‘ 162(l). The reason for the retroactive deletion was that
section 89 was retroactively repealed by the same Act and never took effect.
Thus, the statute has always required that a plan be established under a trade or
business. Generally, the earned income from only that trade or business can be
considered. However, if the self-employed individual establishes, for instance, a
medical plan under business A and a dental plan under business B, the earned income
from each business is considered.
Therefore, taking into consideration the limitations under section I.R.C. ‘ 162 (l)
discussed above:
1) A sole proprietor who purchases health insurance in his or her individual name
has established a plan providing medical care coverage with respect to his or her trade
or business, and therefore may deduct the medical care insurance costs for himself, his
spouse and dependents under I.R.C. ‘ 162(l) but only to the extent that the cost of the
insurance does not exceed the earned income (as defined in I.R.C. ‘ 401(c)) derived by
the sole proprietor from the specific trade or business with respect to which the
insurance was purchased;
2) A self-employed individual may deduct the medical care insurance costs for
the self-employed individual and his or her spouse and dependents under a health
insurance plan established for his trade or business up to the net earnings of the
specific trade or business with respect to which the plan is established, but a selfemployed individual may not add the net profits from all his or her trades and
businesses for purposes of determining the deduction limit under I.R.C. ‘ 162(l)(2)(A).
However, if a self-employed individual has more than one trade or business, he or she
may deduct the medical care insurance costs of the self-employed individual and his or
her spouse and dependents under each specific health insurance plan established
under each specific business up to the net earnings of that specific trade or business.
CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS
None
This writing may contain privileged information. Any unauthorized disclosure of
this writing may undermine our ability to protect the privileged information. If disclosure
is determined to be necessary, please contact this office for our views.
3
Please call (202) 622-6080 if you have any further questions.
__________________
Harry Beker
4
Instructor Notes – Chapters 6 and 7
Deductions
Key point: Deductions for AGI can be claimed whether or not the taxpayer itemizes on Schedule A.
Deductions from AGI result in a tax benefit only if, collectively, they exceed the taxpayer’s standard
deduction. Deductions from AGI also include a deduction for qualified business income (QBI), which will
be discussed later.
Typical Deductions for AGI
o
§162 – Business Expenses
i.
Key criteria – “Ordinary, necessary, and reasonable”
ii.
Deducted on Schedules C and F
o
§212 – Investment Expenses
i.
Key criteria – “production of income; maintenance of income property”
ii.
Deducted on Schedule E – Related to rental properties
The book notes that: 1) taxes paid on investments and investment interest expenses are
possible Schedule A deductions allowed under §212; and 2) all other investment
expenses are miscellaneous itemized deductions, which are currently not deductible
under the TCJA. While this is technically true, the deduction for taxes and interest are
covered in different sections of the law (see 26 U.S.C §§ 163 and 164). In effect, this
means that investment expenses under section 212 are only deductible on Schedule E.
TCJA essentially eliminated the Schedule A portion of investment expenses (see page 13
of the instructions for Schedule A).
o
Other Deductions
i.
Many of these deductions can be found on page 2 of Schedule 1 of Form 1040.
ii.
Examples:
i.
Educator Expenses ($250 / year) – §162(a)(2)(D)
ii.
MSA, HAS, and SE Health Insurance – Sections 220, 223, and 162(l)
(See IRS Chief Counsel Memo in Canvas)
iii.
IRA, SEP, and SIMPLE Retirement Plans – §219 and §408
iv.
½ SE Tax Deduction – §164(f)
v.
Student Loan Interest – §221
vi.
Alimony paid (pre-2018); moving expenses (military only); and expenses
of certain types of employees.
iii.
Copy of IRS Schedule 1 page two is provided on the following page as an
example of the possible other deductions available to taxpayers.
Instructor: Jerome Jenkins
Page 1
Instructor Notes – Chapters 6 and 7
Typical Deductions from AGI
These deductions fall into two groups: Qualified Business Income deductions (QBI); and itemized /
standard deductions. QBI will be discussed later. Standard deductions were discussed previously.
o
Common Itemized Deductions
i.
Medical Expenses (only if they exceed 7.5% of AGI) – §213
ii.
Taxes (state income, sales, real estate, and other) – §164
iii.
iv.
v.
Mortgage Interest (limited to the interest on $750,000 in debt) – §163(h)(3)
Investment Interest (limited to net investment income) – §163(d)
Private Mortgage / Qualified Mortgage Insurance (PMI) – §163(h)(3)(E)
vi.
Charitable Gifts – §170
vii.
Casualty & Theft Losses – §165
Instructor: Jerome Jenkins
Page 2
Instructor Notes – Chapters 6 and 7
Summary
Method of Accounting
o
Cash Method – Typically can deduct when paid. Can also include expenses paid with
borrowed funds.
Example 1 – The taxpayer uses $10,000 in cash to pay for employee wages in year 1.
The $10,000 is deductible in year 1 because it was paid in year 1.
Example 2 – The taxpayer uses $10,000 in cash to pay for employee wages. The
employees worked in December of year 1. However, the taxpayer did not pay the
employees their wages until January of year 2. The $10,000 is deductible in year 2
because it was paid in year 2.
Example 3 – The taxpayer borrows $10,000 to pay for employee wages in year 1. The
$10,000 is deductible in year 1 because it was paid in year 1. This is true even though
the taxpayer used borrowed money.
o
Accrual Method – Typically can deduct when incurred. Based on the All Events Tests.
Broadly, these tests include: (1) all of the events have occurred to create the taxpayer’s
liability and (2) the amount of the liability can be determined with reasonable accuracy.
Instructor: Jerome Jenkins
Page 3
Instructor Notes – Chapters 6 and 7
Example 1 – The taxpayer uses $10,000 in cash to pay for employee wages in year 1.
The $10,000 is deductible in year 1 because it was paid and incurred in year 1.
Example 2 – The taxpayer uses $10,000 in cash to pay for employee wages. The
employees worked in December of year 1. However, the taxpayer did not pay the
employees their wages until January of year 2. The $10,000 is deductible in year 1
because it was incurred and owed / fixed in year 1.
Example 3 – The taxpayer borrows $10,000 to pay for employee wages in year 1. The
$10,000 is deductible in year 1 because it was paid and incurred in year 1. This is true
even though the taxpayer used borrowed money.
Possible Disallowances and Limitations
Not all business expenses and payments are deductible under §162. Some expenses, while necessary,
are contrary to public policy. Others are specifically limited or prohibited as an operation of tax law.
Below are some specific disallowance examples:
o
o
o
o
o
o
Bribes and kickbacks – 162(c)
Lobbying and political expenses – 162(e)
Fines and penalties – 162(f)
Anti-trust violation damages – 162(g)
Excessive employee compensation – 162(m)
Sexual harassment damages and legal fees – 162(q)
Instead of a complete disallowance, the tax code often will often limit certain deductions to either 1) the
associated income (think hobby losses and personal use / below market rentals); 2) a specific
percentage of income (think charitable contributions), or 3) to certain percentage of the amount of the
expense (think meals and entertainment). Below are some specific limitation examples:
o
Hobby losses – §183. The tax code refers to these as businesses not engaged in for
profit. This has been an area of considerable tax litigation. What separates a business
from a hobby is a factual inquiry, and is not defined in the tax code. Hobby expenses are
limited to hobby income based on an ordering regimen. If a business turns a profit 3 out
of 5 (2 out of 7 for horse related businesses), it is presumed to be a for profit enterprise.
See the IRS Audit Technique Guide in Canvas.
o
Vacation / personal use rentals – §280A. These are rentals rented at less than fair
market value or where the taxpayer’s use of the property generally exceeds more than
14 days. If vacation rental expenses exceed vacation rental income (i.e. a loss), the loss
is suspended and carried forward to the next year or until the property is sold.
Conversely, §280A(g) excludes both the income and expenses if the property is rented
for less than 15 days.
Example 1: The taxpayer owns a house at the beach. The taxpayer rents out the house
at market rates on Airbnb all year. When not in use by paying customers, the taxpayer
will visit the property. However, use by the taxpayer never exceeds two weeks. In this
case the property is a rental, not a vacation home.
Instructor: Jerome Jenkins
Page 4
Instructor Notes – Chapters 6 and 7
Example 2: The taxpayer owns a house at the beach. The taxpayer rents out the house
at market rates on Airbnb for most of the year. However, the taxpayer stays at the
property each year during the summer months. Since the taxpayer’s use exceeds two
weeks, property is a likely a vacation home, not a true rental.
Example 3: The taxpayer owns a house at the beach. The taxpayer rents out the house
at below market rates to friends and family. When not in use by paying customers, the
taxpayer will visit the property. However, the taxpayer’s actual use never exceeds two
weeks. Since any day rented at less than fair market value is considered a personal use
day, the taxpayer is deemed to have used the property personally as vacation home (i.e.
not a true rental).
Example 4: The taxpayer owns a house in a historic neighborhood. The taxpayer lives in
the house all year. Occasionally, the taxpayer will rents out the house to film production
companies as a movie set. However, use as a rental never exceeds two weeks. In this
case the property is a personal residence and both the income and expenses are
excluded.
Instructor: Jerome Jenkins
Page 5
Instructor Notes – Chapters 6 and 7
Capital Expenditures
Generally, these are long-life asset purchase. They are depreciated and are not deductible as expenses.
However, under §179 and 168(k), many capital expenditures can be fully “expensed” or 100%
depreciated in the first year. This will be covered in more detail in Chapter 8.
o
Other Points:
i.
Generally, repairs are not capital expenditures unless they substantially improve
the associated property.
ii.
Taxpayers can elect to expense capital purchases under $5,000 (de minimums).
Personal Expenses and Related Party Transactions
o
No deduction is allowed for personal expenses. This is because: 1) they are specifically
excluded (§262) and 2) there are no code sections that specifically allow for the
deduction.
o
No losses are allowed on sales between related parties. Related party transactions are
complicated and are subject to a lot of limitations. As a general rule, know the parties
to a transaction. If they are family, review the rules of §267 carefully. Below if how the
code defines related parties:
i.
Brothers and sisters (whether whole, half, or adopted), spouses, ancestors
(parents and grandparents), and lineal descendants (children and grandchildren)
of the taxpayer.
ii.
A corporation that is owned more than 50 percent (directly or indirectly) by the
taxpayer.
iii.
Two corporations that are members of a controlled group.
iv.
A series of other complex relationships between trusts, corporations,
partnerships, and individual taxpayers
o
In addition to the relationships above, the constructive ownership rules also apply when
determining if someone is a related party. Basically, if I own corporation 1, and
corporation 1 owns corporation 2, I am the constructive owner of corporation 2.
Substantiation Requirement
The tax law requires taxpayers to keep books and records and to be able to substantiate (prove) their
expenses in audit (see §6001).
This is commonly called the burden of proof (civil audit only). In general, taxpayers have the burden of
proof with respect to deductions. IRS has the burden of proof with respect to any allegation of
additional income. Taxpayers, at all times, must report their true income.
Losses
Losses are generally deductible. However, where losses get deducted on Form 1040 and how they are
treated depends on a number of factors. The main consideration is whether a loss was related to a
business or if it was related to something personal.
o
Business Bad Debts:
Instructor: Jerome Jenkins
Page 6
o
Instructor Notes – Chapters 6 and 7
i.
If a debt is the result of unpaid invoices or sale, and the taxpayer uses the cash
basis of accounting, no deduction is allowed. This is similar to the tax benefit
rule. Since the sale was never reported in income, no deduction for the loss is
allowed.
ii.
If the taxpayer uses the accrual method of accounting, a bad debt deduction is
allowed. This would typically be claimed on Schedule C or F.
Non-Business Bad Debt:
i.
If the debt was the result of an unpaid personal loan, a non-business bad debt
deduction could be allowed. The issue is demonstrating the debt is worthless,
and that the taxpayer made a reasonable attempt to collect. Also, the related
party rules under §267 could come into play here as well, depending on the
facts surrounding the debt.
ii.
If a non-business bad debt deduction is allowed, the taxpayer must claim the
deduction as a short-term capital loss on Schedule D.
Timing of
deduction
Character of
deduction
Recovery of
amounts
previously
deducted
o
If the account recovered was
written off during the current tax
year, the write-off entry is
reversed. If the account was
written off in a previous tax year,
income is created subject to the
tax benefit rule.
Nonbusiness Bad Debts
A deduction is allowed only
when the debt becomes wholly
worthless.
The bad debt is classified as a
short-term capital loss, subject
to the $3,000 net capital loss
limitation for individuals.
If the account recovered was
written off during the current tax
year, the write-off entry is
reversed. If the account was
written off in a previous tax year,
income is created subject to the
tax benefit rule.
Worthless Securities:
i.
Deemed to be written off on the last day of the year.
ii.
o
Business Bad Debts
A deduction is allowed when the
debt becomes either partially or
wholly worthless.
The bad debt is deducted as an
ordinary loss.
§1244 Stock: Losses, up to $100,000 for MFJ, can be treated as an ordinary loss
(not capital) if the terms of §1244 are met. The term small business stock is
more expansive in §1244 than the definition of qualified small business stock in
§1202 (covered later)
Casualty and Theft Losses
i.
Related to personal and business property. Prior to 2018 the law was more
expansive. Now, losses are only allowed in federally declared disaster areas for
personal property.
Instructor: Jerome Jenkins
Page 7
ii.
Instructor Notes – Chapters 6 and 7
Business casualty losses are deductible in two ways:
• For a complete loss, the loss is treated as a deemed sale. Any insurance
proceeds reduce the loss. The starting point for the loss computation is
the adjusted basis of the property.
•
Example: In year 1, a taxpayer purchased an office building that is used
in the taxpayer’s business. The building and land were purchased
together for $1,000,000. The building was valued at $600,000 in year 1.
Prior to year 5, the taxpayer claimed $50,000 of depreciation on the
building. During year 5 the building was completely destroyed in a fire.
The insurance company provided a final payment of $600,000 for the
loss on the building.
Computation:
Insurance proceeds:
(-) Adjusted basis of the building:
Gain on deemed sale:
$600,000
$550,000
$ 50,000
Note: This gain may be postponed or deferred under §1033 if similar a
replacement property is purchased.
•
For a partial loss, the calculation compares the loss in FMV of the
property damaged to the adjusted basis for the property. If the FMV
lost is less than the adjusted basis, only the decrease in FMV is allowed.
Similarly, insurance proceeds reduce the loss.
•
Example: Assume all the same facts as the example above, however: 1)
the fire only destroyed 10% of the building; 2) the building had a FMV of
$700,000 before the fire and $630,000 after the fire; and 3) the
insurance company only paid $50,000.
Computation:
Decrease in FMV:
Adjusted Basis:
$ 70,000 (lesser value)
$550,000
Insurance proceeds:
(-) Loss in FMV:
Loss on deemed sale:
$ 50,000
$ 70,000
$ -20,000
Note: This loss will likely be reported on Form 4797. The loss deducted
likely will reduce the adjusted basis of the property per §1016.
iii.
Business theft losses are deductible in the year of discovery.
iv.
Personal losses can be deducted on Schedule A, if related to a federally declared
disaster, and reduced by $100 + 10% of AGI.
Instructor: Jerome Jenkins
Page 8
Instructor Notes – Chapters 6 and 7
Summary from Textbook:
Business Use or IncomeProducing Property
Any event.
Personal Use Property*
Amount
The lesser of the decline in FMV
or the adjusted basis. Always the
adjusted basis if total loss.
The lesser of the decline in
fair market value or the
adjusted basis.
Insurance
Insurance proceeds received
reduce the amount of the loss.
Insurance proceeds received
(or for which there is an
unfiled claim) reduce the
amount of the loss.
$100 floor
Not applicable.
Applicable per event.
Gains and losses
Gains and losses are netted (see
Chapter 17).
Personal casualty and theft
gains and losses are netted.
Gains exceeding losses
See Chapter 17.
The gains and losses are
treated as gains and losses
from the sale of capital
assets.
Losses exceeding gains
See Chapter 17.
The gains—and the losses to
the extent of gains—are
treated as ordinary items in
computing AGI. The losses in
excess of gains, to the extent
they exceed 10% of AGI, are
itemized deductions.
Event creating the loss
Casualty or theft.
Research Expenses – Election.
o Expenses (prior to 2022);
o Defer and amortize over 60 months starting when a benefit is realized; or
o Capitalize each year and amortize over 5 years (1/2 year in first year).
Excess Business Losses (NOL)
o When expenses exceed income, this creates a net operating loss (NOL). NOLs are first
deducted against other income that year, and then carried forward to future tax years
and deducted as an NOLD.
o The other reported income on the loss year tax return is referred to in the text as the
threshold amount.
o Generally, (2021 and onward) loss carryforward is the only option. A various times, carry
back provisions were in effect prior to 2021.
o NOLDs do not reduce self-employment taxes. This is because NOLDs are deducted on
Schedule 1, not Schedule C.
o Computation:
Instructor: Jerome Jenkins
Page 9
Instructor Notes – Chapters 6 and 7
Taxable income shown on the return
+ Personal and dependency exemptions (suspended from 2018 through 2025).
+ Net operating loss carryover from another year.
+ The qualified business income deduction (§ 199A).
+ The excess of nonbusiness capital losses over nonbusiness capital gains.
+ The excess of nonbusiness deductions over the sum of nonbusiness income plus net
nonbusiness capital gains.
+ The excess of business capital losses over the sum of business capital gains plus the
excess of nonbusiness income and net nonbusiness capital gains over nonbusiness
deductions.
= The net operating loss
Flow-Through Losses
o Losses from S-Corporations and Partnerships are put through a series of tests to
determine if and how they are deductible. The main tests are as follows:
i.
Basis (generally the initial cash investment and subsequent contributions)
ii.
At risk (generally any amount required to be paid back)
iii.
Passive (to see if it is currently deductible or carried forward)
iv.
Capital (testing for ordinary loss or a capital loss)
Looking Ahead – Discussion Questions:
Question 1
Expenses related to rents and royalties are deductible under §212 or, in the case of a real property trade
or business, possibly under §162. However, many investment expenses are deducted on Schedule A (i.e.
not deducted for AGI). Explain why this is the case. Cite an IRC section or administrative regulations to
support your answer.
Question 2
Since casualty losses are deducted on Schedule A, does a taxpayer have to itemize to claim the benefits
of a casualty loss? What if the taxpayer wants to claim the standard deductions, since their other
itemized deductions do not exceed the basic standard deduction? Can a taxpayer claim both the
standard deduction and a casualty loss?
Question 3
Does the tax code treat businesses differently depending on the type of business? Are there limitations
on deductions for marijuana related businesses, such as growers and dispensaries? Discuss some of
these restrictions and the related tax code sections.
Instructor: Jerome Jenkins
Page 10
IRC § 183: Activities Not
Engaged in For Profit (ATG)
NOTE: This document is not an official pronouncement of the law or the position of the Service
and can not be used, cited, or relied upon as such. This guide is current through the publication
date. Since changes may have occurred after the publication date that would affect the accuracy
of this document, no guarantees are made concerning the technical accuracy after the publication
date.
Audit Guide Rev. 6/09
Contents
Chapter 1: Introduction and Overview ………………………………………………………………………………. 1
Purpose of Guide…………………………………………………………………………………………………………. 1
Objectives of Guide …………………………………………………………………………………………………….. 1
IRC § 183 Overview ……………………………………………………………………………………………………. 1
Multiple Activities ………………………………………………………………………………………………………. 5
Farming Activities and Farmland Appreciation ………………………………………………………………. 5
Taxpayer’s Subject to IRC § 183 Activities Not Engaged in For Profit ……………………………… 6
Presumption that Activity is Engaged in for Profit …………………………………………………………… 7
Election to Postpone Determination ………………………………………………………………………………. 8
Chapter 2: Examination Techniques ………………………………………………………………………………… 11
Examination Techniques Overview ……………………………………………………………………………… 11
Pre-audit Analysis ……………………………………………………………………………………………………… 11
Information Document Request …………………………………………………………………………………… 12
Initial Interview …………………………………………………………………………………………………………. 12
Place of Examination …………………………………………………………………………………………………. 14
Business/Activity Tour ………………………………………………………………………………………………. 14
Factual Development …………………………………………………………………………………………………. 15
Income Tax Savings Benefit Analysis ………………………………………………………………………….. 17
Chapter 3: Supporting Law …………………………………………………………………………………………….. 18
Internal Revenue Code ……………………………………………………………………………………………….. 18
Treasury Regulations …………………………………………………………………………………………………. 19
Revenue Rulings ……………………………………………………………………………………………………….. 20
Case Law ………………………………………………………………………………………………………………….. 20
Chapter 4: Report Writing ……………………………………………………………………………………………… 21
Calculating the Examination Adjustments under IRC § 183 ……………………………………………. 21
Incorrect Computation Example ………………………………………………………………………………….. 22
IRC § 183(b) Computation Example ……………………………………………………………………………. 23
RGS Input ………………………………………………………………………………………………………………… 25
Partnerships, S Corporations, Trusts and Estates……………………………………………………………. 28
Taxpayer Penalties …………………………………………………………………………………………………….. 30
Return Preparer Penalties……………………………………………………………………………………………. 33
IRC § 6694(a) Understatement Due to Unreasonable Positions ……………………………………….. 34
Unagreed Reports………………………………………………………………………………………………………. 37
Alternative positions ………………………………………………………………………………………………….. 38
Inadequate Books and Records ……………………………………………………………………………………. 38
Appendix ……………………………………………………………………………………………………………………… 40
Appendix A – Treas. Regs. § 1.183-2(b) ……………………………………………………………………….. 40
Factor 1 ………………………………………………………………………………………………………………… 40
Factor 2 ………………………………………………………………………………………………………………… 42
Factor 3 ………………………………………………………………………………………………………………… 43
Factor 4 ………………………………………………………………………………………………………………… 44
Factor 5 ………………………………………………………………………………………………………………… 46
Factor 6 ………………………………………………………………………………………………………………… 46
Factor 7 ………………………………………………………………………………………………………………… 47
Factor 8 ………………………………………………………………………………………………………………… 49
Factor 9 ………………………………………………………………………………………………………………… 50
Appendix B – Suggested Interview Questions for Each of 9 Relevant Factors …………………… 51
Appendix C – Tax Savings Benefit Analysis …………………………………………………………………. 57
Appendix D – Comparative Analysis Income, Expense and Losses ………………………………….. 58
Appendix E – Example of an IDR for a Yacht Charter Activity ……………………………………….. 60
Chapter 1: Introduction and Overview
Purpose of Guide
This audit technique guide (ATG) has been developed to provide guidance to Revenue Agents
and Tax Compliance Officers in pursuing the application of Internal Revenue Code (IRC) § 183,
Activities Not Engaged in for Profit (sometimes referred to as the “hobby loss rule”).
The purpose of the guide is to:




assist in distinguishing between a business activity (where deductions may be allowable
under IRC § 162); a non-business “for profit” activity (where deductions may be
allowable under IRC § 212; an activity not engaged in for profit (where deductions are
strictly limited by specific rules contained in IRC § 183); and a personal activity (where
deductions are generally disallowed by IRC § 262, except to the extent not otherwise
allowable),
provide examination techniques,
supply applicable law, and
provide written guidance in report writing.
This guide is not designed to be all inclusive.
This guide is not legal precedent and should not be relied upon as such. It is not designed to
remove the discretion given to managers and examiners in the application of a variety of audit
techniques or procedures appropriate to any given examination.
Objectives of Guide
Upon completion of this audit techniques guide, the examiner will be able to:
1. Determine when and to whom IRC § 183 may be asserted,
2. Identify and develop relevant factors for making an IRC § 183 determination, and
3. Compute the examination adjustments when a determination is made that an activity is
not engaged in for profit.
IRC § 183 Overview
A number of taxpayers who have significant income from other sources reduce their taxable
income by reporting losses from activities that may or may not be engaged in for profit. It is up
to IRS examiners to make a factual determination whether an activity is engaged in for profit.
On September 27, 2007, the Treasury Inspector General for Tax Administration (TIGTA) issued
a report entitled “Significant Challenges Exist in Determining Whether Taxpayers With
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Schedule C Losses are Engaged in Tax Abuse.” The review looked at high income Small
Business/Self-Employed (SB/SE) taxpayers (total income sources of $100,000 or greater) who
claimed business losses using a U.S. Individual Income Tax Return (Form 1040) Profit or Loss
From Business (Schedule C) for activities considered to be not-for-profit. The results of the audit
found the following:
“In general, if a taxpayer has hobby income and expenses, the expense deduction
should be limited to the hobby income amount. About 1.5 million taxpayers,
many with significant income from other sources, filed form 1040 Schedules C
showing no profits, only losses, over consecutive Tax Years 2002 – 2005 (4
years); 73 percent of these taxpayers were assisted by tax practitioners. By
claiming these losses to reduce their taxable incomes, about 1.2 million of the 1.5
million taxpayers potentially avoided paying $2.8 billion in taxes in Tax Year
2005. Changes are needed to prevent taxpayers from continually deducting losses
in potentially not-for-profit activities to reduce their tax liabilities.”
It is important to note that the report limited their review to Schedule C’s with four years of
consecutive losses and to total income sources of $100,000 or greater. It did not cover Schedule
F farm activities nor did it cover any type of entity other than the 1040.
IRC § 183 generally limits deductions, in the case of an activity engaged in by a taxpayer, if the
activity is not engaged in for profit. The term “activity not engaged in for profit” is defined by
IRC § 183(c) to mean any activity, other than one with respect to which deductions are allowable
for the taxable year under IRC § 162 or under paragraphs (1) or (2) of IRC § 212. IRC § 183
applies to individuals, partnerships, S corporations, trusts and estates. It does not apply to C
corporations.
The determination of whether an activity is an activity not engaged in for profit is a factual
determination. Neither the Code nor the Regulations provide an absolute definition. They instead
serve to provide guidance in formulating the facts necessary to determine whether an activity is a
not for profit activity. Historically, IRC § 183 has been a difficult issue to pursue.
The first “hobby loss” provision in the Internal Revenue Code was enacted by the Revenue Act
of 1943 as IRC § 270. The act was intended to limit the ability of individuals with multiple
sources of income to apply losses incurred in “side-line” diversions to reduce their overall tax
liabilities. IRC § 270 was repealed by the Tax Reform Act of 1969 effective for tax years
beginning after December 31, 1969, and replaced with IRC § 183.
Generally, the Code allows individuals to deduct expenses which are incurred (1) in a trade or
business (IRC § 162); or (2) for the production or collection of income, or for the management,
conservation or maintenance of property held for the production of income (IRC § 212).
For the expenses to be deductible under IRC §§ 162 or 212, the taxpayer must engage in or carry
on an activity to which the expenses relate with an actual and honest objective of making a
profit. Keanini v. Comr., 94 T.C. 41 (1990) (citing Golanty v. Comr., 72 T.C. 411, 425 (1979),
Page 2 of 64
aff’d without published opinion, 647 F.2d 170 (9th Cir. 1981)); Dreicer v. Comr., 78 T.C. 642
(1982), aff’d without opinion, 702 F.2d 1205 (D.C. Cir. 1983).
Taxpayers bear the burden of proving that they engaged in the activity with an actual and honest
objective of realizing a profit. Hendricks v. Comr., 32 F.3d 94 (4th Cir. 1994), aff’g T.C. Memo
1993-396, Comr. v. Groetzinger, 480 U.S. 23, 35 (1987); Bot v. Comr., 353 F.3d 595, 599 (8th
Cir. 2003), aff’g 118 T.C. 138 (2002); Am. Acad. Of Family Physicians v. U.S., 91 F.3d 1155,
1157-58 (8th Cir. 1996).
The taxpayer must devote time to the business in the honest belief that the business will
sometime in the future become profitable. It is necessary for the taxpayer to show what their
projected profit is expected to be.
If an activity is not engaged in for profit, IRC § 183(b) allows a taxpayer the deductions that
would be allowable without regard to whether or not the activity is engaged in for profit. If the
gross income derived from the activity for the taxable year exceeds these deductions, IRC §
183(b) also allows a taxpayer to deduct the amounts that would be allowable as deductions if the
activity were engaged in for profit, to the extent of any remaining gross income.
Treas. Regs. § 1.183-1(e) provides that for purposes of IRC § 183, gross income includes the
total of all gains from the sale, exchange or other disposition of property and all other gross
receipts derived from such activity. It also provides that gross receipts from the activity may be
reduced by cost of goods sold to determine gross income.
It is generally to the taxpayer’s advantage to determine gross income based on gross profit (gross
receipts less cost of goods sold). The examiner should ensure that cost of goods sold is reduced
by any personal expenses or nondeductible items prior to making the gross income computation.
Making a determination as to whether an activity is not for profit has more implications than
whether the loss will be allowed to offset other income. Many other areas on the tax return can
be affected by this determination including but not limited to:







self-employment tax
deductions for health insurance premiums
alternative minimum tax (AMT)
itemized deductions
adjusted gross income (AGI)
personal exemption phase out
Roth IRA contributions
The determination of the proper amount of adjusted gross income can affect many items on the
return, including but not limited to rental losses, medical expenses, casualty losses,
miscellaneous deductions, the adoption expense credit and interest on education loans.
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Also, when there is an IRC § 183 problem, the taxpayer may be subject to AMT since
miscellaneous itemized deductions (where many not for profit expenses end up) are not
deductible for AMT purposes.
Whether or not an activity is presumed to be operated for profit requires an analysis of the facts
and circumstances of each case. Deciding whether a taxpayer operates an activity with an actual
and honest profit motive typically involves applying the nine non-exclusive factors contained in
Treas. Reg. § 1.183-2(b). Those factors are:
1.
2.
3.
4.
5.
6.
7.
8.
9.
the manner in which the taxpayer carried on the activity,
the expertise of the taxpayer or his or her advisers,
the time and effort expended by the taxpayer in carrying on the activity,
the expectation that the assets used in the activity may appreciate in value,
the success of the taxpayer in carrying on other similar or dissimilar activities,
the taxpayer’s history of income or loss with respect to the activity,
the amount of occasional profits, if any, which are earned,
the financial status of the taxpayer, and
elements of personal pleasure or recreation.
No single factor controls, other factors may be considered, and the mere fact that the number of
factors indicating the lack of a profit objective exceeds the number indicating the presence of a
profit objective (or vice versa) is not conclusive. For example, if five factors say the activity is
not for profit, but four are on the profit side, the activity still could be determined to be engaged
in for profit. More weight is given by the courts to objective facts than to the taxpayer’s
statement of his or her intent. Dreicer v. Comr., 78 T.C. 642 (1982).
A profit objective in an earlier year does not automatically provide a taxpayer a blank check with
regard to losses incurred in later years. For example, in a later year an activity may be treated as
an activity not engaged in for profit even though in an earlier year the activity may have been
conducted by the taxpayer with a profit objective. See Daugherty v. Comr., T.C. Memo 1983188; Dennis v. Comr., T.C. Memo 1984-4.
An examiner should not tell a taxpayer that, because he is involved in a particular business
activity, it is not possible to make a profit and his/her losses are therefore disallowed. Each
taxpayer is entitled to be evaluated by a fair, impartial examiner so that a fully reasoned
determination of whether an activity is engaged in for profit can be made.
IRC § 183(d) is a safe harbor for the taxpayer. It allows a presumption that the taxpayer is
engaged in for profit if in 3 of 5 consecutive years (2 of 7 in the case of breeding, training,
showing or racing of horses), the activity is profitable. This is covered in more detail below.
IRC § 183(e) allows the taxpayer to elect to postpone the determination as to whether the IRC §
183(d) presumption applies. This is also covered in more detail below.
IRC §162 allows as a deduction “all the ordinary and necessary expenses paid or incurred during
the taxable year in carrying on any trade or business. A bona fide business must truly exist prior
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to claiming expenses under IRC § 162. An expense may qualify as ordinary and necessary if it is
appropriate and helpful in carrying on a trade or business, is commonly and frequently incurred
in the type of business conducted by the taxpayer, and is not a capital expenditure.” Welch v.
Helvering, 290 U.S. 111 (1933).
A trade or business expense deduction under IRC § 162, however, is not permitted with respect
to a taxpayer’s residence unless specifically permitted in certain limited circumstances by IRC §
280A. An examiner should consult the rules of IRC § 280A (which generally supersede the IRC
§ 183 rules) if the taxpayer’s deductions are suspect and involve a personal residence. See e.g.,
Rev. Rul. 2004-32.
Multiple Activities
Treas. Regs. § 1.183-1(d) provides that if a taxpayer engages in two or more separate activities,
deductions and income from each separate activity are not aggregated either in determining
whether a particular activity is engaged in for profit or in applying IRC § 183. Multiple
undertakings may be treated as one activity if the undertakings are sufficiently interconnected.
The regulations define an activity and provide that where the taxpayer is engaged in several
undertakings, each of these may be a separate activity, or several undertakings may constitute
one activity. In ascertaining the activity or activities of the taxpayer, all the facts and
circumstances of the case must be taken into account. Generally, the most significant facts and
circumstances in making this determination are the degree of organizational and economic
interrelationship of various undertakings, the business purpose which is (or might be) served by
carrying on the various undertakings separately or together in a trade or business or in an
investment setting, and the similarity of various undertakings. Generally, the Commissioner will
accept the characterization by the taxpayer of several undertakings either as a single activity or
as separate activities. The taxpayer’s characterization will not be accepted, however, when it
appears that his characterization is artificial and cannot be reasonably supported under the facts
and circumstances of the case.
If the taxpayer engages in two or more separate activities, deductions and income from each
separate activity are not aggregated either in determining whether a particular activity is engaged
in for profit or in applying IRC § 183.
Farming Activities and Farmland Appreciation
Where land is purchased or held primarily with the intent to profit from increase in its value, and
the taxpayer also engages in farming on such land, the farming and the holding of the land will
ordinarily be considered a single activity only if the farming activity reduces the net cost of
carrying the land for its appreciation in value. Thus, the farming and holding of the land will be
considered a single activity only if the income derived from farming exceeds the deductions
attributable to the farming activity which are not directly attributable to the holding of the land
(that is, deductions other than those directly attributable to the holding of the land such as
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interest on a mortgage secured by the land, annual property taxes attributable to the land and
improvements, and depreciation of improvements to the land). Treas. Regs. § 1.183-1(d).
Some courts have avoided the restrictive rule discussed in the preceding paragraph by finding
that the taxpayer did not purchase or hold the land primarily with the intent to profit from
increase in its value. Instead, these courts have found the taxpayer purchased and held the land
for farming. See e.g., Engdahl v. Comr., 72 T.C. 659 n.4 (1979), acq. 1979-C.B.1. On
distinguishable facts, an opposite conclusion was reached in Burrus v. Comr., T.C. Memo
2003-285.
Taxpayer’s Subject to IRC § 183 Activities Not Engaged in
For Profit
The IRC § 183 activities not engaged in for profit rules applies to (1) individuals; (2) S
corporations; (3) partnerships; (4) and trusts and estates. IRC § 183 does not apply to C
corporations.
Individuals
The provisions under IRC § 183(a) specifically applies to individuals.
S corporations
The provisions under IRC § 183(a) specifically applies to S corporations. Treas. Regs. §1.1831(f) provides that IRC § 183 and this section shall be applied in determining the allowable
deductions of an electing small business corporation.
Partnerships
Rev. Rul. 77-320 holds that IRC § 183 of the Code applies to the activities of a partnership, and
the provisions of IRC § 183 are applied at the partnership level and reflected in the partners’
distributive shares. IRC § 703(a) provides in general that the taxable income of a partner shall be
computed in the same manner as in the case of an individual.
Trusts and Estates
Treas. Reg. § 1.183-1(a) states that “Pursuant to § 641(b), the taxable income of an estate or trust
is computed in the same manner as in the case of an individual with certain exceptions not here
relevant. Accordingly, where an estate or trust engages in an activity or activities which are not
for profit, the rules of IRC § 183 apply in computing the allowable deductions of such trust or
estate.”
C Corporations
The provisions of IRC § 183 do not apply to C corporations.
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Presumption that Activity is Engaged in for Profit
IRC § 183(d) provides a presumption that an activity is engaged in for profit if the activity is
profitable for 3 years of a consecutive 5 year period or 2 years of a consecutive 7 year period for
activities that consist of breeding, showing, training, or racing horses.
This presumption rule applies only after an activity incurs a third profitable (or second)
profitable year within a 5 year (or 7 year) presumption period that begins with the first profitable
year.
Note: Treasury Regulation § 1.183-1(c) has not been updated to reflect the 1986 amendment
increasing the number of profit years required from two to three out of five years for activities
other than horse racing, breeding or showing).
Example 1 – A taxpayer has the following profits and losses with a car racing activity (5 year
presumption period):
Example 1 profits and losses
Tax Year
Gain or (Loss)
2000
(30,000)
2001
5000
2002
(60,000)
2003
2,000
2004
5,000
2005
(70,000)
2006
3,000
2007
(63,000)
The first 5 year presumption period begins with the first profit year of 2001, but the benefit of
the presumption does not begin until the third profit year of 2004. The presumption is not
available for 2001 through 2003 because it does not apply until the third profit year. The
presumption is available during the first presumption period only in 2004 and 2005. The second
five year presumption period begins with the 2003 profit year and runs through 2007. The
presumption applies to the third profit year of 2006 and will be of benefit to the taxpayer for
2006 and 2007.
If the taxpayer meets the presumption rule, the Service can still argue that the activity is not
engaged in for profit; however, the burden of proving that the activity is not engaged in for profit
shifts to the Service. In addition, examiners cannot use IRC § 183(d) as the sole basis for
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disallowing losses under IRC § 183 even if it is shown that the taxpayer has not met the
presumption rule.
Examiners should be alert for situations where the taxpayer may have manipulated income and
or expenses to meet the presumption rule determination.
Election to Postpone Determination
Under IRC § 183(e), a taxpayer may elect to postpone a determination of whether the
presumption applies until the close of the fourth taxable year (or the sixth year for qualifying
horse activities) following the first taxable year in which the taxpayer engages in the activity. An
electing taxpayer may file returns in the interim on the assumption that the activity is conducted
for profit.
If an activity that is generating losses has not yet been carried on for the full profit presumption
period, the taxpayer may elect to postpone a determination of whether or not an activity is
engaged in for profit.
The examiner should first determine whether or not the activity is engaged in for profit from all
available facts without regard to the presumption test or the possible election to postpone
determination under IRC § 183(e). This determination should take into account the “nine
relevant factors” listed in Treas. Reg. § 1.183-2(b) as well as the pertinent facts.
Upon the filing of all or a sufficient number of the returns of the presumption period, the case
file will be returned to the examiner for a determination if the activity is presumed to be an
activity engaged in for profit.
Making the Election
Form 5213, Election to Postpone Determination as To Whether the Presumption Applies That an
Activity Is Engaged in for Profit, is used when taxpayers wish to postpone an IRS determination
as to whether the presumption applies that they are engaged in an activity for profit. An election
made by a partnership or an S corporation is binding on all persons who were partners or
shareholders at any time during the presumption period.
The election to postpone determination generally can be filed anytime within three years after the
due date of the return (determined without regard to extensions) for the first year of the activity
but not later than 60 days after the taxpayer receives written notice from the IRS proposing to
disallow deductions attributable to the activity.
Note: Form 5213 is rarely used by the taxpayer until an examiner proposes to disallow the
activity as not engaged in for profit.
The examiner should determine if the taxpayer wants, and is eligible to elect to postpone the
determination under IRC § 183(e). If the taxpayer makes the decision to make the election, all
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legal and procedural implications should be explained. If the taxpayer is eligible to make the
election but does not wish to, the examiner should obtain a written statement from the taxpayer
or his representative stating that the taxpayer does not wish to elect the provisions of IRC §
183(e).
Placing in Suspense
If there is an election to postpone the determination, the examiner will generally close the case to
suspense until the end of the presumption period. Upon the filing of all or a sufficient number of
the returns of the presumption period, the case file will be returned to the examiner for a final
determination if the activity is engaged in for profit.
If the taxpayer wishes to make an §183(e) election to postpone determination, the examiner
should:
1.
2.
3.
4.
secure fully completed and properly signed Form 5213,
requisition all returns beginning with the initial year,
obtain AMDISA, IMFOLT, IMFOLR for all tax returns,
perform audit functions as warranted, paying particular attention to the full development
of the activity not engaged in for profit issue,
5. examine and complete any open years prior to placing in suspense,
6. prepare a report on each of the open years of the IRC § 183 adjustments,
7. attach a completed Form 3198, Special Handling Notice for Examination Case
Processing, checking the blocks “Suspense Cases” and “Sec. 183 (Form 5213),”
8. make appropriate comments in the workpapers to document the election,
9. advise the taxpayer of the suspense process and to retain all pertinent books and records
for each of the presumptive years,
10. attach the Form 5213 to the back of the first year’s return with the form number showing
above the tax return, and, if applicable,
11. resolve all other issues through partial assessments or unagreed procedures prior to
sending the case to Technical Services for suspense.
A partially agreed report should be prepared if there are other issues which are agreed and
generate a deficiency. One report will contain the agreed issues and the other report only the IRC
§ 183(a) issue as unagreed. IRM 4.10.8.5 contains the report writing instructions for partially
agreed cases.
The Form 4549-A, Income Tax Discrepancy Adjustments, in the “Other Information’ section
should include the following statement:
“You have elected to postpone the determination with respect to the presumption
that this activity is engaged in for profit by filing Form 5213 on (insert date) and
thus, this issue will be suspended.
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On the unagreed report, the IRC § 183(a) issue should be written up as if the case will go directly
to Appeals. The Form 3198 should indicate in the Other Section “Partial Agreement Secured and
Processed.”
If there are other unagreed issues besides the § 183 (a) issue, the unagreed report will contain
both the unagreed issue(s) and the IRC § 183(a) issue(s) before the case is forwarded to Appeals.
The Form 3198 should be notated “Case to be forwarded to Technical Services for suspense after
resolution of unrelated issues.”
It is the IRS’s position that the interest suspension period specified in IRC § 6404(g) is tolled
(ceases to run) during the time the IRC § 183 election is in effect and for the particular activity to
which the election relates.
Statute of Limitations
The filing of Form 5213 automatically extends the period of limitations for assessing any income
tax deficiency specifically attributable to the activity during any year in the presumption period.
Under IRC § 183(e)(4), if a taxpayer elects a postponement, the statutory period for the
assessment of any deficiency attributable to the issue is extended to 2 years after the due date
(without extensions) for filing the return for the last taxable year in the 5 or 7 year presumption
period to which the election relates.
For example, for an activity subject to a 5 year presumption period that began in 2004 and ends
in 2008, the period of limitations automatically extends to April 15, 2011, for all tax years in the
presumption period that would otherwise expire before that date with regards to the § 183 issue.
Note: The automatic extension applies only to those deductions attributable to the activity and to
any deductions (such as medical expenses or charitable contribution deductions) that are affected
by changes to AGI. It does not extend the statute of limitations for issues not related to the IRC §
183 issue.
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Chapter 2: Examination Techniques
Examination Techniques Overview
Once an examiner believes there is a possible activity not engaged in for profit issue, the case
must be adequately developed. In order to adequately develop an IRC § 183 issue, the examiner
must address each of the nine relevant factors contained in Treas. Reg. 1.183-2(b). The nine
factors found in the regulations along with a discussion of each factor are contained in Appendix
A.
An IRC § 183 issue will not be sustained in Appeals or in the courts if it has not been properly
developed and documented.
Included below are examination techniques specific to the IRC § 183 issue. Some of these
techniques are the same or similar to techniques performed on a typical case.
Pre-audit Analysis
It is not always easy to determine from looking at the return if an activity is not engaged in for
profit. Examiners should be alert to see if there is a “reasonable” indication that there is a
“likelihood” of an activity not engaged in for profit in the pre-audit stage of the examination. The
amount of pre-plan time spent will vary with the complexity of the case.
Examiners should consider the following in their pre-audit analysis:




Are there activities with large expenses and little or no income?
Are losses offsetting other income on the return?
Does the activity result in a large tax benefit to the taxpayer?
Does the history of the activity show that it is generating any profit in any years?
Examples of possible IRC § 183 activities include but are not limited to:
Possible IRC § 183 activities
Fishing
Horse Racing
Horse Breeding
Farming
Motorcross Racing
Auto Racing
Craft Sales
Bowling
Stamp Collecting
Dog Breeding
Yacht Charter
Artists
Gambling
Fishing
Bowling
Direct Sales
Photography
Writing
Entertainers
Airplane Charter
Rentals
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An in-depth pre-audit analysis is essential to conducting a quality examination Examiners should
prepare a comparative analysis of the taxpayer’s returns for multiple years to assist in the
identification of:




large, unusual and questionable items,
missing schedules,
inconsistencies between different years, and
audit potential.
A successful taxpayer interview depends upon what is done before the interview. The examiner
should obtain as much information about the taxpayer, be organized, and prepare an interview
outline that is tailored to the taxpayer under examination.
Information may be obtained by the use of internal sources such as IDRS, CFOL, MACS/CDE,
IRP transcripts and YK-1 to learn everything possible about the taxpayer. External electronic
sources of information such as Accurint, Google, Yahoo, and Altavista should also be searched.
This information should be compared with the taxpayer’s return.
Examiners should perform any preliminary research including reviewing applicable code
sections, regulations, court cases, revenue rulings and procedures, and ATGs.
As preliminary information is gathered, it should be carefully reviewed and documented.
Information Document Request
The initial Information Document Request (IDR) for a possible IRC § 183 case should be
tailored to the specific taxpayer under examination but will more than likely be the same as for a
typical case.
The examiner should not issue an IDR asking the taxpayer to respond to each of the nine factors.
This should be done in person with the taxpayer present and the examiner documenting
responses. Also, examiners should not request the Business Plan with the first IDR as this should
be addressed at the initial interview.
Subsequent IDR’s should address other needed information to complete the examination.
An example of an IDR with possible items an examiner might request to assist in determining if
a yacht charter activity is an activity engaged in for profit is in Appendix E.
Initial Interview
An examiner may not become aware that there is a possible IRC § 183 activity until the initial
interview with the taxpayer and/or representative. A subsequent interview may be necessary to
gather the factual information to evaluate each of the nine factors contained in Treas. Reg. §
1.183-2(b). The nine factors found in the regulations along with a discussion of each factor are in
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Appendix A. An effective and well documented interview is vital to the success in developing
an IRC § 183 issue.
The business history should be developed and documented in the examiner’s workpapers.
Interviews provide information about the taxpayer’s financial history, business/activity
operations, and accounting records. Interviews should be used to obtain information needed to
reach informed judgments about the scope of an examination and the resolution of issues.
Interviews can be used to obtain leads, develop information and establish evidence.
A list of possible interview questions to consider for each of the nine factors used in determining
whether an IRC § 183 issue present is in Appendix B. Not all of these questions are warranted in
every case and questions should be tailored to address items specific to the taxpayer under
examination. This interview plan is a guide, which should be modified based upon the responses
of the taxpayer and should not be used as an inflexible outline.
Examiners should use short questions that can be easily understood and in a logical order.
Sufficient questions should be asked to give a clear understanding of the taxpayer’s operations.
Follow-up questions should be used to clarify questionable areas. If both the taxpayer and
preparer/authorized representative are present for the interview, direct the questions to the
taxpayer. Listen to the answers and follow up on any answers that are incomplete or unclear.
The examiner should consider preparing Memorandum of Interview summarizing information
obtained and statements made. This will become part of the case file to aid in the case
development.
Authority to conduct interviews
The authority to conduct interviews and request information is granted by IRC § 7602.
Every attempt should be made to schedule the initial appointment with the taxpayer. IRC §
7521(c) permits a representative authorized by the taxpayer to represent that taxpayer at any
interview. Although a request for the taxpayer’s voluntary presence should be made through
his/her representative, the taxpayer’s presence will not be mandated as long as the person being
interviewed has first hand knowledge of the taxpayer’s business, business practices, bookkeeping
methods, accounting practices and the daily operation of the business. That person must commit
to having first hand knowledge of the information requested and affirm that the examiner can
rely upon the information provided.
A representative may claim to have first hand knowledge, but when questions are asked it is
clear he/she is unable to give adequate answers. If an examiner determines that the representative
does not have sufficient knowledge of the taxpayer and his/her business to provide factual
information, the examiner should request a subsequent interview with the individual who
possesses that information. The examiner should not conduct the audit with someone who will
serve as a courier, shuffling back and forth between the examiner and the taxpayer with IRS
questions and client answers.
Page 13 of 64
If the taxpayer’s representative does not comply with the request to interview someone more
knowledgeable, including the taxpayer, the examiner should consider management involvement,
issuing an administrative summons to the taxpayer (IRC § 7521(c) and/or by-passing the
representative. More information can be found in IRM 4.10.2.and 4.11.55.2.
The examiner may need to use third party contacts order to obtain corroborating information
from third parties.
Place of Examination
IRC § 7605(a) states, in part, that “the time and place of examination shall be such time and
place as may be fixed by the Secretary and as are reasonable under the circumstances.”
For office examination cases the examination will be conducted in the office of the IRS closest to
the taxpayer’s residence in the assigned area.
For field examinations an examination will be conducted at the location where the original
books, records and source documents are maintained. This is usually the taxpayer’s principal
place of the business/activity being examined.
On a case-by-case basis, examiners should consider requests by the taxpayer or representative to
change the place of the examination (Treas. Reg. § 301.7605-1(e).) In considering these requests,
the following factors should be considered:
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The location of the taxpayer’s current residence and location of the business/activity.
The location where the books and records and source documents are maintained.
The physical restrictions at the activity which could cause disruption of taxpayer’s daily
operations.
Business/Activity Tour
Viewing the facilities and observing the activities is an opportunity to acquire an overview of the
operation, establish that books and records accurately reflect operations, observe and test internal
controls, clarify information obtained through interviews, and identify potential audit issues.
Treas. Reg. § 301.7605-1 states “regardless of where an examination takes place, the Service
may visit the taxpayer’s place of business or residence to establish facts that can only be
established by direct visit, such as inventory or asset verification.” The visit can show evidence
of financial status, equipment usage, undisclosed aspects of the operation, etc.
Tours should be conducted after the initial interview and early in the examination process.
Examiners should be alert to the physical surroundings and confirm that assets identified on the
tax return are physically present and identify assets that are physically present but are not
represented on the return. Examiners should ask questions to confirm an understanding of what
is observed.
Page 14 of 64
When determining the validity of office in the home deductions, the office or activity should be
toured.
Examiners should document that a tour was completed and describe the results, including
observations and resolution of any questions. If a tour of the business/activity is not conducted,
the reason(s) for not conducting the tour should be documented in the workpapers.
A Tax Compliance Officer (TCO) does not always have the opportunity to perform a physical
tour of the taxpayer’s activity. However, the TCO can inspect any photographs that the taxpayer
may have of the activity.
Factual Development
Examiners must determine whether the taxpayer engaged in the activity with an objective of
earning a profit. Although a “reasonable” expectation of profit is not required, the profit
objective must be bona fide, as determined from a consideration of the facts and circumstances.
Treas. Reg. §1.183-2(b) (Appendix A) contains nine relevant factors to be used in determining
whether a taxpayer is conducting an activity with the intent to make a profit. An IRC §183 case
is not adequately developed until all nine relevant factors are considered and documented. No
one factor is more important or heavily weighted; a numerical majority does not decide the issue.
The examiner should obtain copies of prior year returns from the inception of the activity and
should prepare a comparative analysis schedule of income and losses (expenses) since the
inception of the business through the present as shown in Appendix D. All trends in profits or
losses should be addressed and explained. Any unusual income items or expense items that occur
and then “drop off” may mean the taxpayer’s profit is contrived. The examiner should consider
whether the profits shown were manipulated in order to meet the presumption test.
Examiners should be alert to the nature of the gross receipts that have been reported and
determine if the income source truly exists or relates to the activity. Income may have been
“created” in order to make it appear as though the activity earned income.
The case file should reflect an adequately documented interview. Each of the nine factors must
be addressed and documented. Sample questions for each factor are contained in Appendix B.
A taxpayer who claims a business expense deduction has the burden of proof. Deductions are
strictly a matter of legislative grace, and taxpayers bear the burden of proving that they are
entitled to the deductions claimed. Hawthorne v. Comr, T.C. Memo 1999-31 (citing Indopco,
Inc. v. Comr, 503 U.S. 79, 84, (1992)).
A taxpayer seeking a deduction must be able to point to an applicable statute and show that he
comes within its terms. New Colonial Ice v. Helvering, 292 U.S. 435, 440 (1934). Also see
Indopco, Inc. v. Comr, 503 U.S. 79, 84, (1993); Rockwell v. Comr, 512 F.2d 882, 886 (1975),
aff’g TC Memo 1972-133.
Page 15 of 64
To take any deduction, the taxpayer must be able to cite an authority: Code, regulations, revenue
rulings, notices. This includes the burden of substantiating the amount and purpose of the
deduction claimed. IRC § 6001 imposes a broad recordkeeping responsibility on all taxpayers,
requiring them to maintain adequate records to substantiate the liability. IRC § 6001 gives the
IRS authority to require whatever records it deems necessary. If the taxpayer proves that a
portion of the expenditure was made for a deductible purpose, the taxpayer may allocate that
portion to the deductible purpose when the record contains sufficient evidence for a reasonable
allocation. See Dillon v. Commissioner, 902 F.2d 406 (5th Cir. 1990).
IRC § 6201 provides examiners with the authority to resolve issues and to make determinations
of tax liability. It also provides broad authority to exercise professional judgment to weigh
conflicting factual information, data, and opinions on issues of law to determine the correct tax
liability.
Factual Development of IRC § 162 Ordinary and Necessary Business Expenses
Like any other examination, the examiner should evaluate each large, unusual or questionable
item to determine its deductibility as a business expense. IRC § 162 allows the deduction of
ordinary and necessary expenses paid or incurred to carry on any trade or business. Examiners
should be alert for personal expenses which may be disguised as business deductions.
Factual Development of Other Non § 183 Issues
Whether or not it is determined that an activity is engaged in for profit, the examiner should
consider whether other Internal Revenue Code sections apply and treat as alternative positions.
Substantiation of all large, unusual or questionable items should be performed on each
examination.
Some of the other Internal Revenue Code sections include, but are not limited to:
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IRC § 704 partnership loss limitations
IRC § 1366 S corporation stock or debt basis limitations
IRC § 465 at-risk limitations
IRC § 469 passive activity loss limitations
IRC § 162 ordinary and necessary
IRC § 274(d) record keeping requirements
IRC § 179 election to expense certain depreciable assets
IRC § 167 and 168 depreciation
IRC § 212 expenses for production of income
IRC § 280A disallowance of certain expenses in connection with business use of the
home, rental of vacation homes, motor homes, houseboats, yachts, etc.
IRC § 195 start up expenses
Taxpayers may use the activity to claim personal expenses. Examiners should be on the alert for
any one or a combination of the following:
Page 16 of 64
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Deducting all or most of the cost of maintaining a personal residence. See IRC § 280A.
Taxpayers sometimes erroneously claim that the “exclusive use” restriction of IRC §
280A can be avoided by placing business-related items in any given room of the house.
The taxpayers sometimes cite the IRC § 280A(c)(2) exception for storage use (storage on
a regular basis of inventory or product samples). For example, the taxpayer may
erroneously claim that if a poster, calendar, desk, file cabinet, telephone or other business
item is placed in a room that secures the room’s business status without regard to the fact
that the room is used for personal purposes as a kitchen, bathroom, child’s bedroom, etc.
Paying children and/or family members for household duties that are not ordinary and
necessary to the operation of any business (e.g. disposing of trash, mowing the law,
answering the telephone, washing cars). Also, the payment may be excessive for the
services performed.
Deducting family education expenses by claiming an Education Assistance Program for
family members claimed as employees. See IRC §127.
Deducting excessive car and truck expenses when the vehicle was used for both personal
and business use. Taxpayers sometimes claim a business purpose for every trip, whether
it is to commute to a regular job or a trip to the grocery store, golf course, church, etc.
Taxpayers sometimes erroneously argue that the trips are deductible given that there is
always a potential of recruiting new clients.
Deducting personal furniture, home entertainment equipment, children’s toys, etc.
Deducting personal travel, meals, and entertainment under the guise that since everyone
is a potential client, these are deductible, not personal expenses.
Deducting 100% of personal medical expenses merely by “employing” a family member
who is not a bona fide employee and creating a medical reimbursement plan.
Income Tax Savings Benefit Analysis
The examiner needs to obtain information regarding the history of the activity under
consideration. This information should be reviewed to see if any profits are being generated in
any years and to determine the overall history of losses exceeding the profits. Completing an
analysis of tax savings is important in developing a § 183 case. The analysis should begin, if
possible, with the first year of the activity.
This analysis should be discussed with the taxpayer and included in the examination report.
A template that can be used in performing an income tax savings benefit analysis is in Appendix
C.
Page 17 of 64
Chapter 3: Supporting Law
Internal Revenue Code
Various code sections may come into play whenever there is an adjustment that may involve IRC
§183, including but not limited to the following:
§ 67(a) – In the case of an individual, the miscellaneous itemized deductions are allowed only to
the extent that the aggregate of such deductions exceeds 2% of AGI.
§ 67(c) – In the case of pass-thru entities (1120S and 1065), a partner or S corporation
shareholder must take into account separately his/her distributive or pro rata share of the
partnership’s or S corporation’s miscellaneous itemized deductions which are subject to the 2%
limitation in IRC § 67(a);
§ 68(a) – Overall limitation on itemized deductions.
§ 162 – A deduction is allowed for all the ordinary and necessary expenses paid or incurred in
carrying on any trade or business.
§ 183 – Provides, generally, that if an activity is not engaged in for profit, deductions are
allowable in the following order and only to the following extent:
1. amounts allowable as deductions during the taxable year without regard to whether the
activity was engaged in for profit are allowable in full (e.g. home mortgage interest, real
estate taxes, etc.);
2. amounts that would otherwise be allowable if the activity were engaged in for profit and
that would not result in an adjustment to the basis of the property if allowed are allowed
only to the extent the gross income derived from the activity exceeds the deductions
allowed or allowable in (1);
3. amounts that would otherwise be allowable if the activity were engaged in for profit that
would result in an adjustment to the basis of the property if allowed are allowed only to
the extent that gross income derived from the activity exceeds the deductions allowed or
allowable in (1) and (2).
§ 212 – An itemized deduction is allowed for individuals for all the ordinary and necessary
expenses paid or incurred for the production or collection of income, for the management,
conservation, or maintenance held for the production of income; or in connection with the
determination, collection, or refund of any tax.
§ 262 – Except as otherwise expressly provided, no deduction shall be allowed for personal,
living, or family expense.
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§ 280A – A trade or business expense deduction under IRC § 162 is not permitted with respect to
a taxpayer’s residence unless specifically permitted in limited circumstances by IRC § 280A(a).
In order for allocable expenses to be deductible, the portion of the taxpayer’s residence must be
used exclusively by the taxpayer on a regular basis as a principal place of business for the
taxpayer’s trade or business, or to meet or deal with patients, clients or customers in the normal
course of the taxpayer’s trade or business. If the taxpayer is an employee, the exclusive and
regular use of a portion of the taxpayer’s residence must be for the convenience of the taxpayer’s
employer before any expenses relating to the part of the taxpayer’s residence may be deducted.
§ 465 – This code section limits a taxpayer’s deduction for losses from an activity to the amount
at risk. IRC § 465 applies to activities in which the taxpayer is engaged in carrying on a trade or
business or for the production of income. Therefore, for the rules of IRC § 465 to apply, the
taxpayer must be engaged in the activity for profit. Accordingly, an activity subject to IRC § 183
cannot be subject to IRC § 465 in the same year. If IRC § 465 applies, any loss in excess of the
taxpayer’s amount at-risk cannot be deducted in the current year. If the taxpayer has no personal
liability, but has pledged property as security for repayment of the debt, the amount at-risk is the
fair market value of the pledged property, less any superior liens. If the taxpayer pledges
property that is used in the activity as security, that property does not increase the amount at-risk.
There is a special rule for real estate activities – a nonrecourse loan qualifies as an amount at-risk
if it is “qualified non-recourse financing.”
§ 469 – Passive losses in excess of passive income are nondeductible. A passive activity is any
rental activity or any business activity in which the taxpayer does not materially participate. If
the average customer use is 7 days or less, the rental activity falls outside the rental definition
and is treated like a business subject to material participation. If the average customer use is 30
days or less, and there are significant personal services, the activity falls outside the rental
definition and is treated like a business subject to material participation.
§ 704 – A partner’s distributive share of partnership loss shall be allowed only to the extent of
the adjusted basis of such partner’s interest in the partnership.
§ 1366 – A S corporation’s shareholder’s pro rata share of loss is not deductible if the loss
exceeds the shareholder’s basis in his or her stock, plus certain debt basis.
Treasury Regulations
Below are applicable Treasury regulations:
1.183-1 – General information for IRC § 183.
Caution: Treasury Regulation § 1.183-1(c) has not been updated to reflect the 1986 amendment
increasing the number of profit years required from two to three out of five years for activities
other than horse racing, breeding or showing).
Page 19 of 64
1.183-2 – Nine relevant factors to be used in determining if an activity is engaged in for profit.
These factors are included in their entirety in Appendix A.
Revenue Rulings
Rev. Rul. 55-258 – holds that income received in an activity not engaged in for profit must be
included in taxable income but is not subject to self-employment tax.
Rev. Rul. 75-14 – holds that the rental of a house to a relative at less than the full fair market
value and less than the total expenses attributable to the house is an activity not engaged in for
profit within the meaning of IRC § 183. Therefore, the taxpayer may only deduct the expenses to
the extent allowable under Treas. Reg. 1.183-1(b)(1) provided he itemizes deductions.
Rev. Rul. 77-320 – holds that IRC § 183 of the Code applies to the activities of a partnership,
and the provisions of IRC § 183 are applied at the partnership level and reflected in the partners’
distributive shares.
Rev. Rul. 2004-32 – holds that taxpayers cannot use schemes designed to create the appearance
of having a home-based business, where none actually exists, for the purpose of converting
otherwise nondeductible personal, living or family expenses into purportedly legitimate
deductions.
Case Law
There are numerous court cases which discuss IRC § 183. Some opinions are taxpayer-favorable
while other opinions support the Government’s position.
Where the specific facts warrant, the examiner should cite cases both favorable and unfavorable
to the Government. The taxpayer or authorized representative should be requested to provide any
cases which defend the taxpayer’s position.
Page 20 of 64
Chapter 4: Report Writing
Calculating the Examination Adjustments under IRC § 183
When the examiner has determined that the taxpayer falls under the provisions of IRC § 183, it is
important to calculate the proper adjustments.
A common error is for the examiner to simply disallow the net loss from the activity. Income
must be reported on the 1040, line 21, as unearned income and expenses that fall in category 2
and/or 3 are deductible only as miscellaneous itemized deductions. These category 2 and/or 3
deductions are subject to the 2% of AGI limitations (IRC §67) and the overall limitation on
itemized deductions (IRC § 68). Also, an individual may be subject to alternative minimum tax
since miscellaneous deductions are not deductible for alternative minimum tax purposes.
Gross Income
Treas. Reg. 1.183-1(e) provides that for purposes of IRC § 183, gross income derived from an
activity not engaged in for profit includes the total of all gains derived from the sale, exchange,
or other disposition of property, and all other gross receipts derived from such activity. Gross
income may be determined from any activity by subtracting the cost of goods sold from the gross
receipts as long as the taxpayer consistently does so and follows generally accepted methods of
accounting in determining such income.
Deductions
If an activity is not engaged in for profit, deductions are allowable under IRC § 183(b) in the
following order on the Schedule A and only to the following extent:



Category 1 – First, deduct expenses that are allowable without regard to the taxpayer’s
profit motive from the gross income produced by the activity. For example, taxes,
mortgage interest, casualty and theft losses, and contributions. These expenses are not
limited by gross income from the activity since they are allowable under other sections of
the Internal Revenue Code regardless of whether or not such activity is engaged in for
profit. These expenses should appear in the proper places on the Schedule A and be
allowed in full after taking into account any limitations such as the limitation on excess
investment interest.
Category 2 – Second, deduct expenses that would be allowable if the activity were to be
engaged in for profit. For example, rent, labor, wages, travel, transportation, etc. These
expenses are limited to the amount of gross income less the expenses in Category 1.
Category 3 – Third, allow deductions which lead to basis adjustments (e.g. depreciation,
amortization and the portion of casualty losses that is not deductible in Category 1).
These expenses are limited to the amount of gross income from the activity less the
expenses in Categories 1 and 2. If there is any gross income remaining after Category 1
and 2 items, the depreciation must be allocated to each depreciable asset.
Page 21 of 64
The allowed expenses are reported as itemized deductions possibly subject to the overall
limitation on itemized deductions and subject to the 2% AGI floor for miscellaneous itemized
deductions. Also, for alternative minimum tax purposes, no deduction is allowed for
miscellaneous items, as defined in IRC § 67(b).
Incorrect Computation Example
The following is an incorrect computation and examiners should not use this method.
Schedule C has gross receipts of $13,000 from a direct sales activity not engaged in for profit.
After expenses of $50,000, the per return ordinary loss is $37,000.
An example for incorrect computation
Gross Receipts
$13,000
Less Expenses (Mortgage Interest)
$-2,000
Less Expenses (Supplies, Repairs, Etc.)
$-11,000
Balance of Gross Receipts
Remaining Expenses ($50,000 – 13,000) = Incorrect Adjustment
$0
$37,000
In the above example, AGI would only have been increased by $37,000 and no adjustments
would have been made on the Schedule A.
The correct method would have been to increase AGI by $50,000 by:
1. removing the $13,000 of gross receipts from the Schedule C;
2. reclassifying the $13,000 of gross receipts from Schedule C to other income (line 21 of
the Form 1040);
3. removing all $50,000 in expenses from the Schedule C;
4. allowing $2,000 as a Schedule A mortgage expense deduction (Category 1 item); and
5. allowing $11,000 (Category 2 items) as Schedule A miscellaneous itemized deductions
subject to the 2% AGI limitation.
By utilizing this method there will be an additional adjustment due to the miscellaneous itemized
deductions limitation and possible other adjustments due to the possible overall limitation on
itemized deductions, and other items (e.g., exemption deduction, AMT and change in AGI which
could affect other items on the return.)
Activities not engaged in for profit expenses are deductible only as Schedule A items, therefore
individual’s who do not itemize cannot claim any deductions attributable to an IRC § 183
activity.
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IRC § 183 adjustments are permanent adjustments unlike passive activity losses which are
timing adjustments. Any adjustments made due to IRC §183 are not permitted to be carried
forward.
IRC § 183(b) Computation Example
The following computation shows how to correctly compute the deductions allowable under
IRC § 183(b).
An examiner is auditing a horse breeding activity and made the determination that it is not
engaged in for profit. The AGI per return is $125,000 which includes the Schedule F loss of
$64,000. All expenses on the Schedule F have been verified. The Schedule F loss is computed as
follows:
The Schedule F loss computation
Schedule F Gross Income
$23,200
Expenses
$87,200
Schedule F Loss Per Return ($64,000)
Step 1 – Remove gross income of $23,200 from the Schedule F.
Step 2 – Reclassify income of $23,200 as other income – unearned, to line 21 of the Form 1040.
Step 3 – Remove all $87,200 expenses from the Schedule F.
Step 4 – Compute corrected AGI
The corrected AGI computation
AGI Per Return
$125,000
Less Schedule F Gross Income ($23,200)
Plus Other Income-Unearned
$23,200
Plus Disallowed Expenses
$87,200
Corrected AGI
$212,200
Page 23 of 64
Step 5 – Sort expenses into Categories 1, 2 and 3
Expenses sorted into different categories
Expense
Amount Category 1 Category 2 Category 3
Real estate taxes
6,000
6,000
Mortgage interest
12,000
12,000
Insurance
1,600
1,600
Utilities
4,200
4,200
Cell Phone
400
400
Veterinary Visits
2,000
2,000
Auto
6,000
6,000
Repairs
16,000
16,000
Feed
8,000
8,000
Depreciation
31,000
Total
87,200
31,000
18,000
38,200
31,000
Step 6 – Determine amount of Category 1, 2 and 3 expenses allowable.
Determine amount of Category 1, 2 and 3 expenses allowable
Gross Income
$23,200
Less Category 1 Expenses
(18,000)
Maximum Category 1 and 2 Deductions
$5,200
Less Category 2 Expenses*
(5,200)
Remaining Gross Income to offset Against Category 3 Expenses 0
* Category 2 items which are deductible to the extent of gross income remaining after Category
1 items (and subject to IRC §§ 67 and 68).
The Category 2 expenses of $5,200 must further be reduced under IRC §67 by $4,244 (2% of the
corrected AGI – 2% X 212,200). The itemized deduction limitation under IRC § 68 applies but
not enough facts have been presented to determine this limitation.
There is no amount of gross income remaining for Category 3 expenses.
Page 24 of 64
In this example, if the loss had simply been disallowed it would have resulted in a $64,000
adjustment. By moving the expenses to the Schedule A it resulted in an additional adjustment of
$4,244 due to the miscellaneous itemized deduction limitation under IRC § 67 and possibly other
adjustments due to the change in AGI.
RGS Input
Leadsheets
A leadsheet is available on IRC § 183 Activities Not Engaged in for Profit and should be used
when the examiner determines that there is a possibility that an activity is not for profit. This
issue should be categorized as de minimis with Per Return and Per Exam fields being zero. The
compliance information will be completed with Reason Code 52, Form/Schedule X and Line
number 99. For the NAICS code, enter “D.”
All workpapers and supporting documentation pertaining to the development of the IRC § 183
issue should be contained in the Activities Not Engaged in for Profit leadsheet and should be
included with the report issued to the taxpayer. The supporting documentation should include a
schedule which shows how each category 1, 2 and 3 expenses were arrived at along with the
factual development of the case addressing each of the nine relevant factors found in Treas.
Reg.§1.183-2(b) used in determining whether a taxpayer is conducting an activity with the intent
to make a profit.
The actual adjustments should be made in each income and expense leadsheet and reference
made to the documentation contained in the IRC § 183 leadsheet. If an expense item is adjusted
because of lack of verification or reasons other than IRC § 183, the supporting documentation
and conclusions should be contained in each individual issue leadsheet and be treated as an
alternative position in the event that, on appeal, the primary activity not engaged in for profit
position is overturned.
Entering Adjustments in Report Generation Software (RGS)
After determining the expense categories and limitations, the adjustments need to be entered in
RGS.
Each income and expense item on the schedule used to report the activity should be disallowed.
Items should not be combined into one adjustment. The issues for these items may already be
classified and created. Reason Code 10 or 14 should be used only if the item is allowed in full
elsewhere on the return. All adjustments using Reason Code 10 or 14 must net to zero.
Appropriate reason codes should be used for other adjustments.
Reason Code 10 description is “Income/Expenses entered on wrong item to reduce tax or
increase credits.” This reason code should be made to issues when penalties are applied
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Reason Code 14 description is “Taxpayer entered item on the wrong form, schedule or line” for
any expense disallowed which has been allowed in full on the Schedule A. In this example,
Reason Code 14 would be used for all of the Category 1 expenses. This reason code should be
made when no penalties have been asserted and the item has been allowed in full on the
Schedule A.
An issue must be created moving the “earned income” to “unearned income (line 21 of Form
1040)” for the activity. This income should be categorized as “other income – unearned.” Issues
must be created separately for any Category 1 expenses fully allowable on Schedule A, e.g.
mortgage interest, real estate taxes. An additional issue must be added for any other Category 2
and 3 allowable miscellaneous itemized deductions (these items may be grouped into one
adjustment.) These Category 2 and 3 expenses are limited by the gross income from the activity
after subtracting Category 1 expenses.
Partnerships and S Corporations
Where a flow through entity is engaged in several activities, if the activities are separate, the
expenses and income from both may not be aggregated in order to apply the limits of IRC § 183.
Flow through entities are required to ‘separately state” certain items of income and deductions.
Items must be ‘separately stated” if the item would result in a tax liability for any
partner/shareholder different from the person’s tax liability, if the items weren’t ‘separately
stated.’ E.g. charitable contributions, portfolio income, IRC § 179 deduction, investment interest
expense.
Each income and expense item on the schedule used to report the activity should be disallowed.
Income from an activity not engaged in for profit should be categorized separately in RGS as
“Other Income’ for both the Schedule K and K-1. Similarly, expenses should be grouped by
category (1, 2 or 3) and categorized as ‘other deductions’ and deducted only up to the extent of
hobby income. Any remaining deductions should be categorized as non-deductible expenses.
The non-deductible expenses will result in a reduction in the investor basis. An issue should be
created in RGS to reflect the non-deductible expenses.
1040 Schedule C Example
An examiner is auditing a Schedule C bass fishing activity not engaged in for profit with $3,000
of gross income. The taxpayer had $120,000 of AGI. The following Schedule C expenses were
reported and verified by the taxpayer:
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1040 Schedule C Example
Expense
Amount Category 1 Category 2 Category 3
Property taxes
700
700
Mortgage interest
900
900
Insurance
400
400
Utilities
700
700
Auto/Travel
23,000
23,000
Bait/Tackle
2,000
2,000
Entrance Fees
8,000
8,000
Depreciation
28,000
Total
63,700
28,000
1,600
34,100
28,000
Total expenses reported on the Schedule C were $63,700 resulting in a net loss of $60,700. The
Schedule C was classified as a potential activity not for profit and all income and expense items
were classified.



Category 1 expenses total $1,600
Category 2 expenses total $34,100
Category 3 expenses total $28,000
Category 1 expenses of $1,600 are allowed in full leaving $1,400 remaining of gross income for
Category 2 and 3 expenses. Since Category 2 expenses totaling $$34,100 exceed the remaining
gross income of $1,400, the taxpayer is allowed only $1,400 of the Category 2 expenses. None of
the Category 3 expenses may be allowed since there is no remaining gross income remaining.
Step 1 – Remove Income from Schedule C
The first step in RGS is to remove the Schedule C income. Enter $3,000 in the Per Return field
Enter zero in the Per Exam field. For the NAICS code enter “D” in the Per Exam field (the
Schedule C is disallowed in full).
Step 2 – Add an issue for Other Income – Unearned
Add an issue as a New Issue Resulting from a Classified Issue. Categorize the adjustment as
Other Income – unearned (this income is not subject to self employment tax). Enter zero in the
Per Return field. Enter $3,000 in the Per Exam Field.
Step 3 – Remove All Schedule C Expenses
In the example, all Schedule C expenses have been classified. Disallow the Category 1 expenses
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in full by entering zero in the Per Exam field. Use Reason code 10 or 14 only if the item is
allowed in full elsewhere on the return. Enter “D” in the NAICS code Per Exam field. Note that
if these issues had not been classified the examiner would need to add each individual expense
item as a separate adjustment into RGS.
Step 4 –Allow Category 1 Expenses on Schedule A
Category 1 expenses are allowable in full on Schedule A without regard to gross income
limitations. Add each issue as a New Issue Resulting from a Classified Issue. In this example
there are two separate adjustments – one to mortgage interest and one to real estate taxes. Use
Reason Code 10 or 14.
Step 5 – Allow Category 2 and 3 Expenses on Schedule A
The remaining allowable expenses ($3,000 income less $1,600 category 1 expenses) are limited
to the remaining income from the activity and entered as Schedule A Miscellaneous Itemized
Deductions subject to 2% of AGI. One adjustment can be made for the combined expenses. In
this example, the taxpayer will have $1,400 of Category 2 expenses. There is no remaining
income with which to offset Category 3 expenses.
AGI Per Return
120,000
Sch C Expenses Disallowed
63,7…

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