Hobby – When the Tax Office No Longer Recognizes Losses

As a business owner, your goal is to build a successful company and generate profits. Of course, a company can also go through tough times and may incur losses. Tax law stipulates that taxes should only be levied when there is an increase in profitability. Put simply, taxes must therefore only be paid if the company successfully earns money. If losses are incurred in a given year, no taxes need to be paid, of course. It gets even better: losses can be offset against profits. This so-called loss carryforward is initially applied horizontally, i.e., within the same type of income. Losses can also be offset against prior and future profits. Alternatively, losses can be offset against a different type of income. This provision is essential for companies in crisis. However, the loss regulation is sometimes exploited. The tax authorities have therefore become very cautious and often assume that the activity is a hobby. In this article, as tax advisors in Düsseldorf
and Oberhausen
, we will explain what “hobby” entails and examine a relevant recent case from the tax court.

How is the loss carryforward exploited?

Saving on taxes is always nice. There are few to no loopholes in tax law that would allow one to evade tax liability. However, loss carryforward is an area that regularly causes problems and debate. In principle, the recognition of losses is important and essential for companies that incur losses despite their best efforts. Losses are not uncommon, especially for young companies.

We have already mentioned that—as long as no other profits are generated in the same income category—losses can also be offset against other sources of income. This enables the following scenario:

• An entrepreneur has a sole proprietorship that is successfully operating in the market and generating profits.
• However, the entrepreneur also has a second—possibly young—sole proprietorship that has been incurring losses for several years.
• Vertical loss offsetting would make it possible here to offset the losses from the second business against the profits of the other business. Consequently, less tax would need to be paid on the income of the successful business.

This provision is important and helpful for many businesses in such a situation. However, you can surely imagine how such an approach could be exploited. As a successful entrepreneur, one could open a business for personal reasons and simply accept the losses, since they can be easily offset. A classic example would be a vacation rental that is officially listed for rent. However, no guests come, and the apartment is used only for private vacations. The costs—and thus the losses from the vacation rental due to the lack of income—could simply be offset against “normal” income for tax purposes. Such an approach is, of course, not in the tax authority’s interest. To prevent precisely such tax evasion, there is the so-called “hobby” classification.

What is a hobby?

A hobby is defined as an activity where it is assumed that losses are simply accepted for personal reasons. If a type of income is defined as a hobby, it is not eligible for tax consideration. But when is an activity considered a hobby?

The key question here is the intent to generate income. For a business—and thus its profits and losses—to be recognized for tax purposes, there must be an intent to generate income. This means that a business and its losses are only considered relevant if the entrepreneur in question is actually trying to make the business successful. It must therefore be evident that the entrepreneur is actively trying to avoid a loss or make a profit. In the example of the vacation rental mentioned above, the entrepreneur would, for instance, need to try to advertise the property. However, if the vacation rental is not advertised at all and is not listed on any relevant portals for potential accommodations, it can be assumed that the entrepreneur is not attempting to be successful or is even, ideally, not interested in attracting any customers at all. If there is no intention to generate income and no efforts on the part of the entrepreneur (restructuring measures), the activity is presumed to be a hobby.

A hobby means that the entrepreneur carries out the activity solely out of personal interest and does not intend to develop it into a genuine business. Consequently, this activity is not recognized for tax purposes. Losses can therefore no longer be offset.

Hobby: Discussions and Problems with the Definition

The basic concept of a hobby is easy to understand. Distinguishing factors and framework conditions are intended to define a hobby and ensure that, in practice, the classification is straightforward and transparent. Unfortunately, the reality is different. There are frequent discussions and legal proceedings because entrepreneurs believe they are not engaging in a hobby. The tax authorities, on the other hand, understandably tend to view activities as hobbies much more readily. In the following example, we would like to present a recent court ruling that should provide a clear and understandable overview of the issue.

Background

The plaintiff was the full-time managing director of a limited liability company (GmbH). Since 2007, she had also operated a fashion store for high-end women’s and men’s clothing as a sole proprietor. The store was located in a small winter sports resort with approximately 2,300 residents. A friend of the plaintiff was employed as a worker in the fashion store. Between 2007 and 2017, the business incurred losses of approximately €800,000. Initially, the tax office recognized the losses through 2012 and offset them against the plaintiff’s other positive income. In 2018, the fashion store ceased operations. For the period from 2013 to 2018, the fashion store was classified as a hobby. Consequently, the losses could not be offset. The plaintiff was convinced that this was a misjudgment and therefore filed a lawsuit in summary proceedings before the Munich Fiscal Court (FG).

Tax Court Decision

The Tax Court dismissed the petition and ruled in favor of the tax authorities. It is indeed a hobby. To help you better understand the decision and possibly recognize parallels to your own cases, we will explain below why the Tax Court ruled in this manner. First, some background on the decision:

• The recognition of losses requires that the taxpayer intends to achieve a “total profit” over the entire duration of their activity.
• While the intention to generate a profit is essential, it is also difficult to verify. Therefore, external characteristics must be used as indicators. For example, it must be determined whether the business is even capable of generating a profit.
• In the case of a loss-making business, it must be examined whether the activity serves to satisfy personal inclinations or to obtain economic advantages outside the scope of tax law, or whether the losses are accepted for personal reasons.
• If neither is the case, the fact that the losses are not addressed with appropriate restructuring measures may lead to the conclusion that there is no intention to achieve a total profit.

In the above-mentioned case, the plaintiff accepted losses for years without taking any action. By 2013 at the latest, she should have realized that the location was not suitable for selling high-end fashion. Also relevant is the fact that only a friend was employed as a staff member in the business. Further indications that this was a hobby included the fact that the company vehicle could also be used for personal trips and that the plaintiff was able to participate in social activities related to winter sports through the business (personal benefit). Overall, it must be assumed that this was a hobby. This was conclusively confirmed by the tax court.

What happens if the tax office considers it a hobby?

As soon as the tax authorities begin to doubt the intent to generate income, tax assessments regarding losses are issued only on a provisional basis. This is a precautionary measure that must also be taken seriously by the business owner. If it later turns out that the activity is indeed a hobby, the tax assessments will be amended to the taxpayer’s disadvantage. Taxes must be paid retroactively, plus interest!

How long are young companies allowed to incur losses?

Losses are not uncommon in the early stages, especially for young and small businesses. As an entrepreneur, you may wonder how long such losses can be tolerated without being deemed a hobby. There is no universally applicable rule on this. However, a period of five years is usually assumed. During this time, losses are still considered “normal.” Afterward, however, the tax authorities will expect restructuring measures or similar actions. If this does not happen, one must expect the undesirable classification as a hobby.

Any questions? Tax Advisors in Düsseldorf and Oberhausen

The topic of hobby activities is interesting and, in fact, highly relevant in practice. We hope this article was insightful and informative. Do you have any questions or need advice regarding hobby activities? As tax advisors in Düsseldorf and Oberhausen, we are the perfect point of contact for any tax-related matters. Our team of qualified professionals is happy to assist you with all your needs. Simply contact us to schedule a consultation.