“Find a Hobby”

Over the years, many colleagues, friends and family who have observed my work habits have suggested, with the best of intentions, that I find a “hobby,” by which they mean something other than a work-related activity (broadly defined) toward which I may redirect my attention and energy.[i] Their entreaties have taken on a more urgent tone over the last several weeks as my focus on legislative proposals and related developments in Washington and Albany (and their significance to our clients) threaten to drive me meshuga.

I have always appreciated these “interventions” – especially when they occurred over a gin martini with olives, accompanied by oysters or a crabmeat cocktail,[ii] at which point they usually turned into pseudo-symposia – but they inevitably lead me into what I hope is a humorous dissertation of how taxpayers with hobbies often get into trouble with the IRS.

A staple of this poor excuse for a monologue is a matter I had several years ago. The taxpayer, a retired professional – not a farmer by trade – owned many acres of land on the outskirts of a fairly well-to-do suburban area. Situated in one corner of the property was the owner’s house, along with a pool and tennis court. The rest of the land, however, constituting over 99 percent of the total acreage, was dedicated to various agricultural activities. There was an apple orchard, the output of which was picked, then boxed before being trucked and sold to local stores; there were chicken coops (with bird netting to protect from raptors[iii]), the eggs from which were gathered and stored in cartons which were then transported and sold to the same local establishments, including restaurants; there were heavy-coated sheep,[iv] capable of withstanding Northeastern winters,[v] that grazed over several adjoining poly-wired[vi] pastures[vii] (over which they were herded using electronically-controlled and timed gates), that were shorn prior to lambing in the spring – the raw wool was then shipped elsewhere to be processed into yarn and dyed, and then returned to be readied for sale; and there were forested areas from which dead trees were felled and, along with storm-felled trees, were cut, split and stacked before being sold to the public as firewood.[viii]

The taxpayer managed the farm and kept meticulous records; several times a day, he would get into his Jeep and crisscross the property to inspect the fences,[ix] look for newly fallen trees, check on the sheep and chickens, etc. The entire operation was run on a skeletal staff of part-time laborers overseen by a foreman, who were not infrequently paid in kind with the products of the farm.[x]

Pretty impressive operation, right? No doubt. And the taxpayer seemed very knowledgeable (at least to a lay person). But the farm never turned a profit. For every year of its operation, the taxpayer’s federal income tax return reflected a loss for the farming operation. And that single fact caught the attention of the IRS.

Why Care?

In general, taxpayers can only deduct hobby expenses – those that are ordinary and necessary for the particular activity – up to the amount of hobby income. If hobby expenses (which must be itemized) exceed hobby income, the hobby loss cannot be deducted from other, non-hobby income.

According to the IRS, a hobby is an activity in which an individual taxpayer is engaged for recreation or pleasure, notwithstanding that it may also generate some revenue. By contrast, a key feature of a business is the profit that the individual taxpayer expects to generate by engaging in the business activity. The income tax treatment of the income and expenses arising from a given activity will depend upon whether the activity is properly characterized as a business or as a hobby.

In distinguishing between a hobby or business activity, one has to take into account all of the facts and circumstances with respect to the activity. A hobby activity is an activity not engaged in for profit. According to the IRS, one must generally consider the following factors (none of which, by itself, is decisive) in determining whether an activity is a business engaged in making a profit:

  • Whether the taxpayer carries on the activity in a businesslike manner and maintains complete and accurate books and records.
  • Whether the taxpayer has personal motives in carrying on the activity.
  • Whether the time and effort the taxpayer puts into the activity indicate they intend to make it profitable.
  • Whether the taxpayer depends on income from the activity for their livelihood.
  • Whether the taxpayer’s losses are due to circumstances beyond their control (or are normal in the startup phase of the type of business).
  • Whether the taxpayer has the knowledge needed to carry on the activity as a successful business.
  • Whether the taxpayer was successful in making a profit in similar activities in the past.
  • Whether the activity makes a profit in some years and how much profit it makes.
  • Whether the taxpayer can expect to make a future profit from the appreciation of the assets used in the activity.[xi]

In light of the foregoing, what could be said of the taxpayer’s farming operations, as described above? The IRS asserted that they constituted a hobby, notwithstanding the business-like manner in which the farm was managed and operated. After all, the IRS reasoned, who continues to run a business that consistently runs at a loss and that requires the constant infusion of capital to cover its revenue shortfalls?

I’ll tell you who – a taxpayer whose real property taxes are determined based upon their land’s agricultural assessment rather than on its full assessment, which in this case meant land suitable for development – it was the significant savings in property tax dollars that made the farming operation “profitable.”[xii]

In the end, it turned out well for the taxpayer.[xiii] Just last week, however, I came across a decision in the case of a less fortunate taxpayer.[xiv]

What Business?

Over several years, Taxpayer carried on some form of farming activity on a large tract of land. Every year, Taxpayer reported net losses from this activity.[xv]

Initially, Taxpayer raised chickens on the property to sell for meat. That activity did not go well; indeed, Taxpayer could not recall whether they ever sold any of the chickens. After three or four years, Taxpayer switched from raising chickens for meat to raising them for egg production. Within a year, however, Taxpayer had determined that she would not make money with commercial egg production because of an upward trend in the price of chicken feed. Taxpayer switched from commercial egg production to building a flock in order again to sell chickens for meat. Taxpayer purchased approximately seventy birds. There were no sales in the first two years, but Taxpayer planned to begin sales in the third year. Unfortunately, this plan was thwarted when wild dogs destroyed most of the flock.[xvi]

During this period, Taxpayer was also growing watermelons, squash, peppers, apples, bananas, pomegranates, date palms, and asparagus on the property. Taxpayer claimed the expenses of growing those crops as farming expense deductions, but reported no revenues from sales. The lack of revenue was due to the fact that the property bordered the edge of a large evaporative salt plant, and a spill from the plant created a salt flat on a portion of the property. Moreover, evaporation from the salt plant blew across the property and poisoned the soil.[xvii] Thus, crops grown on the property were not commercially acceptable. Taxpayer planted a test crop of peppers, which was not successful because insects destroyed the crop. Taxpayer did not market produce from the property.

Taxpayer also acquired three cows and three calves. The plan was simple: “Feed the calves, make them big, sell them, impregnate the mothers * * * repeat.” That plan did not work because, as Taxpayer explained: “[I]t quickly became apparent that we weren’t going to make money on cows because when I turned them out onto the [land], they couldn’t find enough to eat. * * * We immediately got rid of the cows.”[xviii]

By this time, a reasonable person would have: (a) sold the land, (b) sought the services of a reputable shaman to remove a curse,[xix] (c) given up farming, (d) shot themselves, (e) played the stock market, or (f) taken up golf.[xx] Clearly, Taxpayer was anything but reasonable.

Taxpayer explained the impetus behind their progression from activity to activity:

“When you have something in a business that is not making money, you change it, and you figure out why it’s not making money. You evaluate to see if you could make it make money. If it doesn’t, you stop doing that – and you start doing something else. * * * [W]e have tried several things on this property; so far, nothing has worked. * * * Will something come along that will work? When the right opportunity comes, financial conditions change, market conditions change, then yes, I fully expect to be able to make a profit. At the present moment, no, * * * [we] don’t.”

For the tax years at issue, Taxpayer reported the gross income and expenses from their farming activities. The IRS disallowed Taxpayer’s deductions for the farming losses, explaining that Taxpayer did not incur those losses carrying on a trade or business.[xxi] Following the issuance of a notice of deficiency, Taxpayer petitioned the U.S. Tax Court.

The Court

The Court considered whether Taxpayer’s farming-activity rose to the level of a trade or business.

Section 162 of the Code, the Court explained, allows “as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business”. The IRS argued that Taxpayer could not deduct the farming activity losses under Section 162 because (a) Taxpayer lacked a profit motive, and (b) Taxpayer’s business had not even commenced during the years at issue – rather, Taxpayer’s “farm activity never moved beyond initial research and investigation into an operating business.”

The Court acknowledged that Section 183 of the Code generally disallows any deduction attributable to an activity not engaged in for profit. However, the Court also stated that Taxpayer had convinced the Court, “notwithstanding seven fallow years,”[xxii] that Taxpayer was actually seeking to earn a profit from farming.

Nevertheless, the Court agreed with the IRS that, during the years at issue, Taxpayer’s activities were for the most part preoperational and, for that reason, the losses could not be deducted.

The Court observed that, in order for expenses to be deductible under Section 162(a), the expenses must relate to a trade or business functioning when the expenses were incurred. A taxpayer has not “‘engaged in carrying on any trade or business’ within the intendment of section 162(a)”, the Court explained, “until such time as the business has begun to function as a going concern and performed those activities for which it was organized.” “Carrying on a trade or business” the Court continued, “requires a showing of more than initial research into or investigation of business potential.”

“Until the time the business is ‘performing the activities for which it was organized,’ expenses related to that activity are not currently deductible.” They are instead classified as “startup” expenses – which include those incurred “before the day on which the active trade or business begins” – are only deductible over time once an active trade or business begins.[xxiii]

Startup Costs

Section 195(a) provides that no deduction shall be allowed for startup expenditures, which are defined to include, among other things, any amount paid in connection with creating an active trade or business, which, if paid or incurred in connection with the operation of an existing active trade or business, would be allowable as a deduction for the taxable year in which paid or incurred. Such expenditures may, at the election of the taxpayer, be treated as deferred expenses that are allowed as a deduction prorated equally over a 15-year period beginning with the month in which the active trade or business begins.

During the years at issue, Taxpayer’s farming activities never moved beyond initial experimentation and investigation into an operating business. The Court noted that there was some question of whether to treat all of Taxpayer’s farming activities as one activity or as separate activities for determining whether Taxpayer had commenced any active trade or business. In the end, the Court concluded that it may not make much difference because Taxpayer did not segregate costs by activity.

What’s the Point?

Stay away from golf? Absolutely. Avoid hobbies altogether? Of course not – just be careful of claiming deductions on your tax return in respect of a “hobby” that generates any income.

That said, it felt good to write about something tax-related other than the Democrats’ likely use of the reconciliation process to enact a number of federal tax increases,[xxiv] probably within the next couple of months, or about the pressures on Albany to tax the “rich” on their way out of New York.[xxv]

On reflection, maybe moving to a farm isn’t such a bad idea. It won’t be easy, and I’ll have a lot to learn but, to borrow from Garrison Keillor, it would be “A life in which people made do, made their own, lived off the land, lived between the ground and God.”[xxvi] That doesn’t sound so bad, does it?


[i] “Take up golf,” some have said. This is often followed by “It’s a great game.” (Some even refer to it as a sport!) My reply: “I’d rather develop a pizza allergy.” For those who know me, and of my love for pizza, that’s saying a lot.

[ii] It’ll be a long time before we can indulge in such sessions again.

[iii] Reminds you of Foghorn Leghorn and Henery Hawk? “You’re a chicken and I’m a chicken hawk. Are you comin’ quietly, or do I have to muss ya up?!”

[iv] My mom hails from a tiny village in a hollow among the mountains of northwestern Epirus. The rocky land was not arable, but it could sustain a few goats and small family gardens.

[v] The taxpayer learned the hard way that not all breeds of sheep are equal – earlier acquisition succumbed to the cold.

[vi] To keep coyotes out.

[vii] Over time, the taxpayer experimented with using different forage that has been adapted for the Northeast.

[viii] The taxpayer opened the farm to the public at designated hours on certain days of the week; he also hosted elementary school and Scout groups.

[ix] He told me how he once caught some folks trying to steal one of his sheep. They stopped their car on the road that ran along the edge of one of the pastures, got out, somehow made it over the fence, identified their victim, and were in the process of packing the poor thing into the back seat of the car when he came upon them.

[x] I visited the farm a few days before a scheduled tour by the IRS examiner. (Yes, I wore a suit and shoes, yes it was a gray day that turned into a rainy one, yes we got out of the Jeep several times, and yes, it was muddy. Happy?

Anyway, there were two or three smallish tractors parked together near one of the buildings. When I asked how they were used, the taxpayer told me they hadn’t been operated in years. I asked him not to volunteer that information.

At one point, we stopped at a barn in which, along with the tools one might expect to find in a barn, was something quite unexpected: a Jaguar – no, not the big cat, the automobile. I suggested that he remove it before the examiner’s visit. (I can tell you I held my breath on the day of the examiner’s inspection as the taxpayer opened the barn’s gate – thankfully, the car was gone.)

[xi] See Reg. Sec. 1.183-2(b).

[xii] I suggested that he consider an agricultural easement. He had other plans: he hoped to hold onto the property until his passing, in order to obtain a basis step-up. IRC Sec. 1014. In that way, his family, none of whom lived nearby, could eventually sell the property without paying income tax.

[xiii] The disallowance of certain deductions that could not be adequately substantiated. Taxpayer’s burden.

[xiv] Costello v. Commissioner, T.C. Memo 2021-9 (Jan. 25, 2021).

[xv] On Form 1040, Schedule F, Profit or Loss from Farming.

[xvi] A not-so-subtle message from above?

[xvii] Lot’s wife would have understood all too well.

[xviii] You can’t make this up.

[xix] Seriously, who would ever get into a car with this individual, let alone a plane?

[xx] Obviously, set out in order of preference.

[xxi] The IRS disallowed Taxpayer’s farm-activity losses only to the extent they exceeded her farm-activity income.

[xxii] Query whether the Court or Taxpayer was thinking of Joseph’s interpretation of Pharaoh’s dreams in Genesis 41: 1-36? Only in reverse? Seven years of great abundance, Joseph explained to Pharaoh, would be followed by seven years of great famine. It worked out pretty well for Joseph.

[xxiii] IRC Sec. 195.

[xxiv] Perhaps with retroactive effect? I doubted it until recently.

[xxv] Query whether this will include a California-like provision for like-kind exchanges in which New York real property is exchanged for non-New York real property? Under such a provision, the owner of the non-New York replacement property would have to report annually the New York-sourced gain that was deferred as a result of the like-kind exchange. When such replacement property is sold in a taxable transaction, the taxpayer will be required to inform New York of the sale, and report (and pay tax on) the lesser of the gain from the sale or the deferred New York-sourced gain from the original exchange.

[xxvi] “Hog Slaughter,” by Garrison Keillor.