The Profit Motive: What the IRS Looks For

Learn what factors the IRS looks at to decide whether you're entitled to a business deduction.

Even those engaged in activities like exploring Mars need to be aware of mundane issues--like whether they intend to earn a profit from their activity--if they want to deduct their costs as business activities.

Consider the case of Donald Barker, a multi-degreed scientist who worked on the NASA space shuttle program for many years. Barker ended up in tax court over a dispute about deductions he took for his work related to planning for space exploration. According to the tax court opinion, Barker’s activities included the following. He started a company in 2003 to obtain funding to develop various technologies to explore the planet Mars. Among other things, Barker developed an audio system for space suits to be used on Mars. He attempted to patent his audio system, but the patent was refused. He also published a design study entitled "Solar System Longboats: A Holistic and Robust Mars Exploration Architecture Design Study." Barker attempted to get NASA to help fund his venture, but was unsuccessful. His company never reported any income, according to the tax court opinion.

To deduct business expenses, you must have an active business. If a venture earns a profit in three out of five years, the IRS will presume it's a business. A venture that does not earn a profit can still qualify as a business, but to do so the owner must be able to convince the IRS that he or she engages in the activity primarily to make a profit some time in the future.

Interestingly, a taxpayer need not have a "reasonable expectation" of earning a profit from the activity. All that is required is that he or she have a good faith intention of making a profit. In other words, what's required is good faith, not realism.

So if Barker ran his company with the good faith intent of earning a profit, it qualified as a business. Unfortunately, neither the IRS nor tax court can read a taxpayer's mind to see if he or she is acting in good faith. Instead, they look at a number of objective factors to determine whether or not the taxpayer behaved like a person who wanted to earn a profit. These factors include:

  • whether the activity was operated like a business
  • the taxpayer's expertize
  • the amount of time spent at the activity
  • any expectation that the business's assets may increase in value
  • the taxpayer's success in other activities
  • the history of income or loss from the activity
  • the amount of occasional profit earned
  • the financial status of the taxpayer, and
  • whether the activity contained elements of personal pleasure or recreation.

The tax court examined each of the factors and concluded there was not sufficient evidence to show that Barker had a profit motive for his venture for the year he claimed a deduction. In two areas—his expertise and his expectation that the venture’s assets would increase in value—the court found he satisfied the profit motive requirement. On the other seven factors, however, the court concluded that he did not.

Among its findings, the court noted that Barker did not engage in any marketing or apply for grants during the tax year in question. Instead, the evidence showed only that he attended two conferences. In addition, although he said he kept complete and accurate records, all his records were destroyed in a flood, so there was no evidence for the court to make any determination about his recordkeeping. With regard to the time spent on the activity, the court noted that Barker had multiple jobs and was working on a degree during the year in question. The only evidence regarding his time spent on the venture was that he attended the two conferences as a participant (not a presenter). The tax court didn't doubt that Barker was a passionate exponent of Mars exploration, but concluded that "passion is not synonymous with a profit motive." (Barker v. Comm'r, T.C. Memo. 2012-77.)

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