One Tax Court case said on this point: “Efforts to gain experience, a willingness to follow expert advice and preparation for an activity by extensive study of its practices indicates that a taxpayer has a profit motive.” It is difficult to make a statistical analysis of the issue, but in most Tax Court cases where the taxpayer lost on the hobby loss question, the taxpayer failed to introduce evidence of his or her expertise, or evidence of consultations with those who are experienced in the economics of the industry.
Are You An Expert? How does anyone become an expert? A police detective who comes to be known as an expert does not get that way studying police science, but by on-the-job experience. “Expert” in the context of the hobby loss rule is a loosely formulated term. It does not mean the same thing as someone qualified to testify in court as an expert witness, but is a less rigid formulation. The IRS views your individual expertise and/or your use of experienced advisers as evidence in your favor under the hobby loss rule. There are two components here: (1) the relative expertise of the taxpayer gained or developed through education and/or experience; and (2) the seeking out of advice from others who are experienced in the industry –particularly if you are not an expert in your own right – and following the advice obtained.
As an expert, you are able to make businesslike decisions without the need to consult outside experts. Many cases have hinged on showing the taxpayer acquired knowledge and even personal expertise by consultations with people in the industry. If you have entered into the activity “as a novice,” you may nevertheless acquire considerable knowledge in many facets of the business after the fact by the informal process of hands-on experience, studying of trade magazines, attending industry events and seminars, and so on. If in a livestock activity you have a history of losses, the IRS will want to see evidence, if any, of what you did to further develop your expertise during the course of engaging in the venture. Evidence would consist of receipts and programs from seminars and classes that you attended, a list of books and other publications that you study, notes from consultations you have had, written recommendations from others, and so on.
A number of Tax Court cases have also emphasized that if you do in fact seek out expert advice, there should be evidence that you followed the advice obtained. Many individuals who convert a hobby into a business have already attained some level of expertise through the years they have engaged in the hobby.
Many individuals have a considerable amount of expertise prior to entering a livestock or other farming activity as a business. The fact that you grew up on a farm can work in your favor to show that you had experience in the subject matter before changing it into a business.
John Alan Cohan is an attorney who has served the farming, ranching and horse industries since 1981.
