As you confront the intricacies of tax rules in study for the Regulation (REG) section of the CPA exam, you’re certain to encounter complex situations in practice CPA exam questions. Before deciding that a practice scenario is too outrageous for expecting in genuine accounting work, you might ask a current tax accountant about common difficulties arising with real taxpayers.
Sometimes, an ill-fated taxpayer goes as far as contesting a matter in Tax Court before learning the correct tax procedures you discover from CPA exam study. Why people resist obtaining CPA advice before pursuing an incorrect tax argument is one of life’s great mysteries. The most plausible reason is that taxpayers subconsciously know a CPA’s accurate opinion doesn’t produce the desirable tax outcome. Unfortunately, wishful thinking by taxpayers doesn’t change reality.
The purpose of CPA exam preparation is learning to locate a correct solution among various facts, even when your decision isn’t advantageous for the taxpayer. A fine example recently entered in Tax Court records is the case of Chris Johnson, whose circumstances relate one of the frequent challenges in tax accounting.
Johnson ran into the hobby loss tax rules. Hobbies occasionally generate income. But, most taxpayers – such as Johnson – incur much more in expenses. Hobby details are sometimes buried within a tax question from REG CPA exam material. These elements are typically not the main ingredients of the question, but their inclusion is part of basic exam trickery.
Income and expenses from hobbies are treated differently than business income and expenses. Not knowing the difference results in severe problems for taxpayers like Johnson. Between 2003 and 2005, Johnson engaged in drag racing activity and sustained losses of over $150,000. He incorrectly treated this as a business and deducted the losses against regular wages from his full-time work as an engineer.
The Tax Court deployed the same reasoning as any CPA and determined that Johnson’s drag racing was a hobby. Johnson lacked a business plan, separate bank account for the racing activity, and business-like records. Coupled with the fact that Johnson obviously failed to consult with business experts, such as a CPA, the Court found that the racing activity lacked a profit motive.
Expenses for a hobby are deductible against hobby income, but are not allowed to create a loss that reduces other taxable income. A taxpayer like Johnson can only deduct the expenses for a hobby activity up to the amount of hobby income. Johnson’s twenty year history of losses from drag racing were too much for the court to believe he had a reasonable expectation of profit.
Tax regulations prescribe 9 tests for identifying an activity as a hobby. When any of these apply to questions in CPA exam review or taxpayer conditions found in accounting work, the special rules about hobby expenses are relevant. People with losses from a legitimate business adjust operations to reverse their misfortunes or else quit altogether. One possible step is consultation with a CPA. When you recognize the distinction between businesses and hobbies, you can keep taxpayers out of IRS trouble and Tax Court.
IRS Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.