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Hobby Losses in S Corporation

Technical topics regarding tax preparation.
#1
jdconn  
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1040 Client has a business (started in 2013) of racing horses that is set up as an S Corporation. I do not prepare the S Corporation. I just see the Sch K-1. So far, there have only been losses. The client supports the business through cash contributions/loans. There are no basis issues. Now, in year six, there are more losses. I believe there is a hobby loss issue but I don't know how to report it since it's coming through an S Corp. I don't think I can deduct the loss. Hobby loss rules for individuals dictate to report income and expenses are no longer deductible.
How do I report income when I don't know what it is?
Thanks for your help.
 

#2
Nilodop  
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You may misunderstand the hobby loss rules. Any expenses that would be allowable evn if it's a hobby are still allowable. Then any that would be allowable if it were a business, not a hobby, are allowable to the extent of the gross income from the activity that's left after deducting the first expenses above. Stated as so in the law:
(b) Deductions allowableIn the case of an activity not engaged in for profit to which subsection (a) applies, there shall be allowed—
(1) the deductions which would be allowable under this chapter for the taxable year without regard to whether or not such activity is engaged in for profit, and
(2) a deduction equal to the amount of the deductions which would be allowable under this chapter for the taxable year only if such activity were engaged in for profit, but only to the extent that the gross income derived from such activity for the taxable year exceeds the deductions allowable by reason of paragraph (1).


But your first question should be who determines whether it is a hobby.
 

#3
jdconn  
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I would imagine that the IRS would have final determination of whether the activity was for profit. In this case, the losses have been significant and it appears that the client can only answer yes to 2 of the 9 determinations of a for profit business. For this case, I am assuming hobby.

I understand the concept of the hobby loss rules but I have read with the new Tax Reform that the income has to be reported but the expenses are no longer deductible on Sch A. Have I misunderstood this?

But my real question relates to the fact that this loss is coming from an S Corporation. Pub 535 mentions that the hobby loss limits must be determined at the Partnership or S Corp level. I guess I could take the Sch K-1 at face value although knowing what I know about the business, this makes me nervous to deduct the loss.
 

#4
Nilodop  
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Have I misunderstood this? . That's correct as to misc. itemized deductions and 212 deductions but what about deductions that would be allowable under 162 if the activity had been an active trade or business, not a mere investment? Suppose the business was operated as a sole proprietorship, with losses reported on Sch C. If IRS treats it as a hobby loss and successfully asserts 183, would the expenses have been 212 or 162 type?
 

#5
Nilodop  
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I guess I could take the Sch K-1 at face value although knowing what I know about the business, this makes me nervous to deduct the loss..I agree that IRS makes the final determination. The tests of various numbers of years relates only to a presumption.

But somewhere in there is a preparer's responsibility, and I have not looked at that question. And for that matter, a taxpayer's responsibility. Nothing in 183 says that it only applies if IRS asserts it.

Is he the 100% shareholder? Why does he not use you for the S corp.? Have you explained the problem you have with claiming the losses?
 

#6
Andrew  
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I agree with Nilodop about preparer's responsibility.

Hobby loss rules do apply to S Corporations.

In Magassy vs. Commr, TC Memo 2004-4, the taxpayer (an S corporation) had the burden of proving that it was engaged in the activity of restoring, chartering, and selling a yacht with the actual and honest objective of realizing profit. The court determined that the S corporation was involved in an activity that was not engaged in for a profit. See the ATG guide for hobby losses for more info.

Sec. 183(d) states that if any activity has been profitable in three or more of five consecutive years (two of seven years for most horse activities), you can still prove your profit motive using the following nine factors:

This list is found in IRS Publication 535 Business Expenses.
1. You carry on the activity in a businesslike manner,
2. The time and effort you put into the activity indicate you intend to make it profitable,
3. You depend on income from the activity for your livelihood,
4. Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business),
5. You change your methods of operation in an attempt to improve profitability,
6. You, or your advisors, have the knowledge needed to carry on the activity as a successful business,
7. You were successful in making a profit in similar activities in the past,
8. The activity makes a profit in some years, and how much profit it makes, and
9. You can expect to make a future profit from the appreciation of the assets used in the activity.

There are a lot of court cases involving activities with horse racing, breeding and hobby losses.
 

#7
jon  
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I had a horse racing operation, S corporation, audited by first the State and three years later by IRS. The first audit was no change because of a divorce started the five years running and he had made some money on breeding. The second audit was a surprise he had done very little of what I had asked from him, surprise they wanted to adjust auto expense by $1,800 and entertainment by $2,100. If there was ever anyone who should have lost I should have, but I think luck is sometimes better than skill. This was a doctor making money in his own business, but it had been decreasing because of time spent on the horse operation. Two years after completion of the audit i withdrew from the client - too many problems in both of his operations. Still have not collected a couple of thousand.
 

#8
Smktax  
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Nilodop wrote:If IRS treats it as a hobby loss and successfully asserts 183, would the expenses have been 212 or 162 type?


If the IRS successfully asserts 183, the expenses would not be deductible under 162 or 212. Sec. 183(c) provides in part:
the term “activity not engaged in for profit” means any activity other than one with respect to which deductions are allowable for the taxable year under section 162 or under paragraph (1) or (2) of section 212.
 

#9
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If the gross income of the activity for three years exceeds the deductions of the activity [the deductions for what period?], bla bla bla, the burden shifts *from* the taxpayer *to* the IRS to establish whether it's an activity engaged in for profit or not.

Is that "three-year income" test applied to the gross income of each of the three years, or to the gross income of three years added together? Go back and read the section again: "If the gross income derived from an activity for 3 or more of the taxable years in the period of 5 consecutive taxable years which ends with the taxable year exceeds the deductions attributable to such activity..." Really not clear, huh?

IMHO, Section 183 is an outstanding example of really lousily-written tax law. We're lucky we don't have to deal with it more often!!
 

#10
Nilodop  
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Per Smktax: Nilodop wrote:
If IRS treats it as a hobby loss and successfully asserts 183, would the expenses have been 212 or 162 type?

If the IRS successfully asserts 183, the expenses would not be deductible under 162 or 212.


That's why I used the words "would the expenses have been".
 

#11
dave829  
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jdconn wrote:But my real question relates to the fact that this loss is coming from an S Corporation. Pub 535 mentions that the hobby loss limits must be determined at the Partnership or S Corp level. I guess I could take the Sch K-1 at face value although knowing what I know about the business, this makes me nervous to deduct the loss.

If you determine that the activity isn't engaged in for profit, I don't think that you can simply disallow the loss, despite the fact that Reg. 1.183-1(f) says that 183 applies at the S corporation level, since there might be deductions included that would otherwise be deductible, such as interest and taxes that exceed the gross income.

I think you need to get a breakdown of the loss into its elements: gross income, otherwise allowable deductions, other deductions, depreciation, and treat these elements as separately-stated items. This seems to be required by section 67(c)(1), which would make the individual deductions allowed (or not) on Schedule A. There’s an example involving an S corporation starting on page 29 of the IRS’s Audit Technique Guide on Section 183:
https://www.irs.gov/pub/irs-utl/irc183a ... profit.pdf
 

#12
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Just curious. If you have determined that the S-corporation activity is a hobby, what do you do? Dissolve the entity? Report the loss as non-deductible expenses?

I wonder because of the caution at the top of the 1120-S form:

"Caution: Include only trade or business income and expenses on lines 1a through 21. See the instructions for more information."
Because on T.A. ten was the most you were allowed
 

#13
Chay  
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dave829 wrote:
jdconn wrote:But my real question relates to the fact that this loss is coming from an S Corporation. Pub 535 mentions that the hobby loss limits must be determined at the Partnership or S Corp level. I guess I could take the Sch K-1 at face value although knowing what I know about the business, this makes me nervous to deduct the loss.

If you determine that the activity isn't engaged in for profit, I don't think that you can simply disallow the loss, despite the fact that Reg. 1.183-1(f) says that 183 applies at the S corporation level, since there might be deductions included that would otherwise be deductible, such as interest and taxes that exceed the gross income.

I think you need to get a breakdown of the loss into its elements: gross income, otherwise allowable deductions, other deductions, depreciation, and treat these elements as separately-stated items. This seems to be required by section 67(c)(1), which would make the individual deductions allowed (or not) on Schedule A. There’s an example involving an S corporation starting on page 29 of the IRS’s Audit Technique Guide on Section 183:
https://www.irs.gov/pub/irs-utl/irc183a ... profit.pdf

Before you do any of that you need to discuss this with the client himself. See if he agrees or disagrees that it's a hobby. If he disagrees, how convincing is he?

If you and your client both agree that the activity is not a trade or business, then the S corporation return was filed wrong. Amending the return should be fairly straightforward.

If you end up disagreeing with your client you may be better off disengaging than getting into it any further.
 

#14
Chay  
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Tenletters wrote:Just curious. If you have determined that the S-corporation activity is a hobby, what do you do? Dissolve the entity? Report the loss as non-deductible expenses?

I wonder because of the caution at the top of the 1120-S form:

"Caution: Include only trade or business income and expenses on lines 1a through 21. See the instructions for more information."

Put the income and any potentially deductible expenses on Schedule K, lines 10 and 12d. Nondeductible expenses on Schedule K line 16c. A corporation can mostly do anything an individual can and doesn't need to be dissolved merely because it's lost its business purpose.
 

#15
dave829  
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Chay wrote:
Tenletters wrote:Just curious. If you have determined that the S-corporation activity is a hobby, what do you do? Dissolve the entity? Report the loss as non-deductible expenses?

I wonder because of the caution at the top of the 1120-S form:

"Caution: Include only trade or business income and expenses on lines 1a through 21. See the instructions for more information."

Put the income and any potentially deductible expenses on Schedule K, lines 10 and 12d. Nondeductible expenses on Schedule K line 16c. A corporation can mostly do anything an individual can and doesn't need to be dissolved merely because it's lost its business purpose.

OP said, "I do not prepare the S Corporation."
 

#16
Chay  
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dave829 wrote:OP said, "I do not prepare the S Corporation."

True, but OP's client still files an S corporation return.

All potential consequences of a hobby determination, including Tenletters' question, are relevant to this thread because they will determine what action OP should take in his situation.
 

#17
dave829  
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Chay wrote:
dave829 wrote:OP said, "I do not prepare the S Corporation."

True, but OP's client still files an S corporation return.

All potential consequences of a hobby determination, including Tenletters' question, are relevant to this thread because they will determine what action OP should take in his situation.

All I was pointing out is that OP didn't prepare the S corporation return, so this puts him in a bit of a situation. Assuming that OP has a discussion with his client and they agree that the S corporation activity is a not-for-profit activity, what do you advise OP to do? Prepare an amended 1120S? Go back to the preparer of the 1120S and have an amended filed? What if the preparer of the 1120S disagrees? Should he advise the client to do something else?
 

#18
Chay  
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dave829 wrote:Assuming that OP has a discussion with his client and they agree that the S corporation activity is a not-for-profit activity, what do you advise OP to do? Prepare an amended 1120S? Go back to the preparer of the 1120S and have an amended filed?

I think it depends on what OP finds out from the client. If the issue has never been raised by the S corp preparer in the past, have the client raise it with him.

The end outcome should be that whatever is filed for this trade or business has a reasonable basis - either through analysis using the nine factors in Regs. 1.183-2(b) or through changing the treatment to hobby treatment. If hobby treatment is preferred an amended return should be filed, and I would only suggest doing it over the other preparer if he's being difficult about it.

dave829 wrote:What if the preparer of the 1120S disagrees? Should he advise the client to do something else?

In the end it's up to the client.

I think it's fine to file a return for a client under a position that you disagree with as long as that position has a reasonable basis. The support for the position should be well documented. Your personal disagreement doesn't really come into play - you just go over it on a professional level with how likely the argument is to succeed, why, and what the consequences would be if it doesn't.

If the other preparer can't get over himself and do things this way, he'll either convince the client to keep things the way they are or refuse to amend the return. If the client becomes convinced of a position that lacks support, consider disengaging. If the preparer refuses, offer to amend the return and take over for the other preparer.
 

#19
dave829  
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Chay wrote:If the preparer refuses, offer to amend the return and take over for the other preparer.

Odd that you don't mention the Form 8082 option.
 

#20
Chay  
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dave829 wrote:
Chay wrote:If the preparer refuses, offer to amend the return and take over for the other preparer.

Odd that you don't mention the Form 8082 option.

This form is filed when "you believe an item was not properly reported on the Schedule K-1 you received". The jurat on Form 1120-S states "I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete". So, at best, Form 8082 could be used with the very first year of the problem, after the taxpayer has unknowingly signed the corporate return and then discovered the error. In any other case, one of the two forms would necessarily have been filed under false pretenses.

Given the high likelihood, from the IRS's perspective, that an 8082 filed against oneself reveals some sort of falsehood, and the fact that something has to change anyways going forward, I would shy away from filing one at all. That's why I didn't mention it.
 

#21
dave829  
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Your post is ridiculous. Of course this form can be used. The IRS would never allege any sort of claim that an 1120S was signed under “false premises” if the loss weren’t claimed on the 1040 because it was a hobby loss.
 

#22
Chay  
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No, it's your post that is ridiculous. You would advise a client to file an 1120-S taking one position under penalties of perjury and then to disagree with himself on that same position on Form 8082 under penalties of perjury in order to continue to work with a tax preparer he disagrees with.
 

#23
Nilodop  
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Is that "three-year income" test applied to the gross income of each of the three years, or to the gross income of three years added together? Go back and read the section again: "If the gross income derived from an activity for 3 or more of the taxable years in the period of 5 consecutive taxable years which ends with the taxable year exceeds the deductions attributable to such activity..." Really not clear, huh?
. That's from Harry Boscoe, above.

Pretty soon, somebody's gonna ask if we can choose between using the Julian and the Gregorian calendars for this stuff.. That's from his good buddy from the same town, in another thread somewhere.
 

#24
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Yeah, this same "ten-square-mile" - as some have described it - town. The people who describe it that way need a spanking. Anyone who fails to distinguish between "ten-square-miles" and "ten-miles-square" and then includes that failure in something they write and publish should be spanked, publicly. Or should that be "publically"?

Is it only that I hear "Dishtrict of Columbia" whenever the Mayor refers to her my fine city by its name, or does she really pronounce the word "district" that way? :o ;) :o
 


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