Summary:
Hobby must be operated like a business to get a tax deduction for the loss. IRS frequently audits businesses that have losses over a number of years.

South Sea Aquarium, Pets and Pet Supplies lost money for eight straight years. The appeals court told the lower court it should not have denied the deduction of those losses just because it was a "sloppy operation."

These are a few facts the Tax Court had set out before the appeal. Although losses averaged $25,400 a year, owner Anthony Ranciato did not try to turn the business around and did little to promote it. Aside from yellow page advertising during the three years the Internal Revenue Service examined, he spent only $91 on business promotion.

Only his family worked in Ranciato's business. His mother put in 40 hours, and he, his wife and two children filled in the remainder of the time. He primarily worked in the evenings and weekends, spending most weekdays working either as an electrician or real estate agent.

The Tax court disallowed the losses saying this was a hobby. The appeals court, however, sent the case back for reconsideration. It said the lower court ruled against Ranciato mainly because he ran the business poorly, failing to consult experts or change operations to counteract losses. The implication, said the appeals court, is "the more incompetent the businessman, the less entitled he is to tax deductions." The law "is not designed to penalize those who run businesses ineptly or unwisely, but only to deny tax benefits to those who deliberately engage in financially unprofitable activities." It said the lower court gave too much weight to the "sloppy operation." It should consider that Ranciato "is a solid middle-class wage earner" who didn't deliberately attempt to shelter income.

The Tax court, for the second time, disallowed the loss deductions for the three years the IRS examined, a total of $76,148.

It explained the reasons for the ruling:

• True, courts disallow losses where wealthy people enter an activity producing artificial losses offsetting income. But middle-class wage earners are not exempt. Here, the facts show Ranciato did not have a realistic profit objective.
  
• The store wasn't operated like a business. Records were haphazard and incomplete. He didn't even maintain inventory records.
  
• He knew nothing about this type of business nor did he investigate factors that would result in a profit.
  
• Though he gained almost no pleasure, he operated the store mainly out of affection for his mother. She enjoyed working with the pets.
  
• Though the activity had profitable years when it started operating, these don't offset continuous losses for eight years.
  

Comment. Though a business loses money for years, many taxpayers will say they should be allowed to deduct the losses because they intended to make a profit. The rule: People can deduct losses if they have an actual, though unrealistic, profit objective. Whether they do, however, is based on the facts, as in this case, not what they say they intended. For more cases on this issue, go to www.taxfables.com and click on Hobby vs. Business.

THE MORAL: Hobby losses are a pet peeve of the IRS.