At what point does a hobby become a business? This is an issue that the IRS and taxpayers have grappled with over the years. Significantly, you can claim a loss from a business activity, but deductions for a hobby are limited to the amount of income from the hobby. As a result, the matter often ends up in the Tax Court.
In the latest example, a retired police officer who collected and sold law enforcement patches claimed losses for seven years in a row. Predictably, the Tax Court disallowed the losses (Grago, TC Sum. Op. 2017-67, 8/24/17).
To claim a deductible business loss, you must show that you’re legitimately engaged in the activity to turn a profit, whether you do so or not. When push comes to shove, the courts will examine the following nine factors in the prevailing regulations.
1. The manner in which the taxpayer carries on the activity;
2. The expertise of the taxpayer or his or her advisers;
3. The time and effort expended by the taxpayer in carrying on the activity;
4. The expectation that the assets used in the activity may appreciate in value;
5. The taxpayer’s success in carrying on other similar or dissimilar activities;
6. The taxpayer’s history of income or losses with respect to the activity;
7. The amount of occasional profits, if any, which are earned;
8. The financial status of the taxpayer; and
9. Any elements indicating personal pleasure or recreation.
The taxpayer in the new case had been employed in various capacities as a law enforcement officer over a career that spanned about 23 years. He retired from the field in 1997 as a result of a medical disability.
According to his testimony, the taxpayer began collecting law enforcement patches as a teenager. Law enforcement patches typically are embroidered designs that are sewn onto an officer’s uniform. When he retired from his last job, the taxpayer began to create an electronic database of his collection of law enforcement patches.
At the time of trial, the database comprised about 25,000 files, each of which includes a photograph of a patch and a statement or history about the law enforcement agency that issued the patch. The taxpayer maintains the database on DVDs and on a website which he calls the “California Patch Book” (CPB). He actively buys and sells patches on eBay.
In 2013, the taxpayer decided to begin collecting law enforcement badges with the aim of creating a California Badge Book, akin to the CPB. Law enforcement badges are metal emblems normally pinned to an officer’s uniform. He purchased numerous badges in 2013.
For 2017 through 2011, the taxpayer deducted losses roughly between $7,000 and $8,200 a year. In 2012, the loss he claimed exceeded $18,000, while the loss for 2013 totaled $55,000.
The Tax Court weighed the nine factors listed in the regulations. Although the taxpayer spent considerable time on the activity, he didn’t do enough to demonstrate a bona fide intent to turn a profit. In fact, he sustained losses for seven consecutive years. Plus, his recordkeeping was shoddy, further hurting his cause. Based on the facts, the Tax Court denied the losses for the tax years in question.