Situational Awareness: Accurate Financial Recordkeeping and Business Deductions

Aug 22, 2022

Losses are not allowable for an activity that is carried on primarily for sport, as a hobby, or for recreation.¹ The logic behind this is that those activities are typically not engaged in for profit and will predictably generate losses. Allowing these losses to be deducted could then amount to a de facto tax subsidy of personal activities. Despite this sensible approach to truly personal recreational activities, seemingly similar kinds of activities with mixed business and personal elements do sometimes have a sufficient profit motive and genuine commercial reality to give rise to allowable losses (and, in most years, taxable profits). It is well established that if a recreational activity is primarily engaged in for profit, it can give rise to allowable losses under section 162(a).

This raises a difficult line-drawing exercise between activities for which losses are allowed and those for which they are not allowed. Given that sport, hobby, and recreational activities often have mixed motives, and their profit and loss experience can be highly variable, determining in any given set of facts and circumstances whether a hobby or recreational activity has been engaged in as a trade or business for section 162(a) purposes can be challenging.

This topic is frequently litigated. The Blue J Tax data set on whether an activity amounts to a trade or business for purposes of section 162(a) consists of 758 decisions addressing this question over the 35 years from 1987 to 2022. Three-quarters of these 758 decisions found that the activity in question should not be considered a trade or business; the other quarter found that it should be. But there is much more that we can learn from these cases than the relative rate of their outcomes. In addition to the powerful search tools in Blue J Tax that allow users to filter through these decisions by the discrete facts and circumstances of each, we can use enterprise-grade machine-learning techniques to mine these cases for powerful insight into the facts and circumstances that are linked to different outcomes.²

This month in Blue J Predicts, we investigate the importance of maintaining complete and accurate financial records to determine whether horse breeding and related activities will be characterized as being for profit for purposes of the deduction of expenses under section 162(a). To ground our analysis in a particular set of facts and circumstances, we examine the recent Tax Court decision in Skolnick.³

1 Reg. section 1.183-2(a).

2 Visit bluej.com for more information.

3 Skolnick v. Commissioner, T.C. Memo. 2021-139.