Recent U S Tax Court Decision Allows Long History of Annual Losses

In a recent decision (August 14, 2013), the U S. Tax Court ruled that a musician’s long history of annual losses won’t trigger the hobby loss rules [Gullion, Tax Court Summary Opinion 2013-65].  Further, the Court recognized that it takes longer to achieve success in the arts than in other fields.  The taxpayer had substantial losses for seven years (2004-2010) totaling $130,203.  In 2011, the taxpayer finally made a small profit ($647) which was helpful in his argument before the Court.  This decision provides insight into the Court’s thinking regarding the application of the hobby loss rules (which limits deductions to the amount of income) as it relates to those in artistic endeavors.    The umbrella of artistic endeavors, in my opinion, would also include authors, writers and illustrators.

The taxpayer’s documentation of his activities was crucial to his victory.  I have lectured and written repeatedly about the need to document all your “business” activities.  Although he had a full-time job as a computer programmer, his documented activities as a musician provided the substantiation the Court required.

To be engaged in a trade or business within the meaning of Internal Revenue Code (IRC) section 162(a), an individual taxpayer must be involved in the activity with continuity, regularity, and the primary purpose of deriving a profit.  Deciding whether the taxpayer is carrying on a trade or business requires an examination of all of the facts in each case. A taxpayer must conduct the activity with the requisite profit motive or intent for the activity to be considered a trade or business. The taxpayer generally bears the burden of proving that the requisite profit objective existed.  The taxpayer’s profit objective must be actual and honest.  The pertinent regulations set forth a nonexhaustive list of factors that may be considered in deciding whether a profit objective exists.  For a list of these factors, refer to my earlier blog “Professional Writer or Hobbyist?”

The Tax Court reviewed the relevant factors and determined  the taxpayer’s musical activities qualified as a trade or business for purposes of IRC 162.    The Court stated:  “We have recognized that a taxpayer may engage in more than one trade or business at any one time.  It is also well settled that the term ‘trade or business’ includes the arts.”  In addition, “We have found that ‘a history of losses is less persuasive in the art field than it might be in other fields’, as economic success in the arts frequently takes longer to achieve than success in other fields [Churchman v. Commissioner, 68 T.C. at 701-702].”

This case makes clear that documenting all your efforts and activities en route to a profitable business as a writer, author or illustrator will be the key to deducting your annual losses until that is achieved.