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Hobby Losses vs. Business Deductions : A Cattery

In DKD v. Commissioner, decided by the Eighth Circuit on July 17, 2012, the Court of Appeals upheld a Tax Court decision denying expense deductions to a taxpayer who ran an award-winning kitten breeding business. DKD, an Iowa corporation that was run out of the home of its owner and manager, Debra Dursky, was primarily engaged in the business of information technology consulting. However, the corporation also operated a cattery that was in the business of breeding, showing, and selling pedigree kittens - a business that earned DKD four national championship titles between 2003 and 2005. Nevertheless, the costs associated with taking kittens to national competitions, breeding problems, and inadequate revenues from kitten sales resulted in expenses that exceeded the cattery's revenue by more than $60,000 in each year. Ultimately, though DKD was held to be a valid business because of the income from information technology consulting, all of the expenses deducted from the consulting income for the cattery business were disallowed.

Though this decision was a loss for the taxpayer petitioner, the Eighth Circuit made several significant points in its analysis of whether the cattery should be classified as a hobby or a business. Specifically, the Court stated that the mere fact that the cattery's expenses exceeded its income was not enough, on its own, to prove that the cattery was a hobby rather than a business. Additionally, the Court stated that the Tax Court would be incorrect to disallow a business deduction just because the court believed that the venture was unlikely to produce profits. Rather, the Eighth Circuit pointed out, a court must determine whether a taxpayer has a good-faith, subjective intention to make a profit - an issue that requires a factual analysis and will necessarily differ from taxpayer to taxpayer.

If the IRS decides to re-classify a business as a hobby, all related deductions can be summarily denied, despite any books, records, or receipts to the contrary. With this in mind, when the IRS initiates an audit, it is important to consider their strategy and to prepare your records and arguments accordingly.

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