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  • Hobby or a Tax Dodge? What lenders need to know before they make the loan

Your question:

How long can a business show a loss? Aren’t there some rules about hobby losses?

Linda says:

You have seen it…a business that really looks like a hobby, or a tax dodge. When is a business really a business even if running losses?
And can we ever safely ignore a business loss?

A simple, general rule is that if the business makes a profit in 3 of 5 years there will be a presumption of profit motive. For horse-racing, it is 2 of 7 years. Don’t you wonder what lawmaker owned horses?

For a company that does not meet the presumption of profit motive, the IRS takes a closer look.

In a 2005 tax case [Rabinowitz v. Comm. 2005 TCM 188] the taxpayer successfully defended his operation of aircraft chartering as a business. As you might guess, the IRS wanted to classify it as a hobby and the losses nondeductible.

There are nine factors in determining if a ‘business loss’ is not a ‘hobby loss’ and therefore nondeductible:

  1. You carry on the activity in a business-like 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 the amount of profit it makes
  9. You can expect to make a future profit from the appreciation of the assets used in the activity

It occurs to me that a lender can use the same type of criteria. If the borrower is involved in a business that is losing money and counting the loss against them will force you to decline the loan, consider whether it might meet a common sense definition of hobby even if it meets the IRS definition of a business (based on the taxpayer’s judgment). This is most likely with a sole proprietorship but might also apply to other entity types with a high-percentage owner.

Here are Linda’s two factors:

  1. Is it the type of thing many people do for a hobby? (White water rafting, classic cars, artistic endeavor…)
  2. Could the borrower quit tomorrow without repercussions? (No leases to break, no employees to lay off, no loans to pay)

If so, consider calculating cashflow without the loss counted against the borrower’s cashflow. If they qualify under the new calculation, perhaps you can make the loan using the ‘hobby’ nature of the loss as a mitigating factor.

And, if you are reluctant because the borrower has not told you of plans to quit the business, consider if the amount of loss in the ‘business’ would be a problem for you if you knew the borrower was spending that same amount on a hobby. We are allowed to spend money on personal living expenses…even white water rafting. If we have good credit and meet all the other criteria, is it really a problem?

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Linda Keith, CPA

Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis.
She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans.
Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.