IRS Releases New Audit Technique Guide on Hobby Loss Issues

The IRS released an Audit Technique Guide on the Hobby Loss rules under Section 183. The guide, meant to instruct IRS examining agents on procedures to be used to determine if the limitations under §183 may be applicable to taxpayers they are examining, details that the provision applies not only to individuals, but also to partnerships and S corporations.

In its overview section, the guide quotes from a 2007 report of the Treasury Inspector General for Tax Administration that noted that, in reviewing returns of individuals that reported total income of over $100,000, it found over 1.5 million returns that reported Schedule Cs with losses for each of the four years from 2002-2005, suggesting that many of those individuals should have had their deductions limited under §183. The report went to note, rather ominously, that 73% of those returns were prepared with the assistance of paid preparers.

The obvious implication of that report is that a) the IRS should be more vigorous in examining these returns to disallow the claims of losses and b) the IRS should consider taking action against preparers who are signing off on returns containing such claims, such as through application of the §6694 penalties should the position be deemed not to have substantial authority and/or disciplinary action action against Circular 230 qualified preparers by the Office of Professional Responsibility.

All CPAs should be sure they are up to speed on the issues related to the hobby loss rules of Section 183, as well as considering procedures to insure that returns that have Schedule Cs that suffer continuing losses alongside sufficient other income to suggest the taxpayer may not have the proper profit objective are subject to special scrutiny to either advise the taxpayer that they are subject to the limits of §183 or to be sure the CPA’s files contain information that documents why, under the binding authorities that exist on this matter, the taxpayer either has substantial authority for not being subject to these limits or, if disclosure is made on Form 8275 and/or 8275-R (as appropriate) why there existed a reasonable basis for the position.

As well, the ATG may serve as a useful document to both distribute to all tax staff to let them know the IRS’s view of the matter (though always remembering that this is the IRS’s view, which may not always be the view the courts would take) as well as to hand to clients who often are more persuaded by an IRS document, as non-authoritative as we may know it is, than by all the stunningly brilliant research we may put forth them in a letter or memorandum.