Mona viewed herself as a creative individual who had chosen to go to law school for economic reasons. Mona's undergraduate majors were creative writing and American Indian studies.
Mona was very successful as an attorney and eventually was admitted to partnership in her law firm, having an expertise in negotiating settlements involving Indian water rights.
While practicing law, Mona continued her interest in the arts. She had directed plays in high school and maintained her involvement in the theater, even during law school. She belonged to local theater organizations while she practiced law. She took several courses in filmmaking and read extensively in the area. She even took several months off from her legal practice to enroll in NYU's filmmaking program. Her enrollment in the program provided her with hands-on experience and taught her about the technical aspects of filmmaking and allowed her to meet individuals who would later work with her on her documentary.
When she discovered that her husband had similar interests, she decided to create a documentary about Way to Sing America. After acquiring the rights to all of the archival footage of Way to Sing America, she hired a video production company to film interviews that she conducted with Way to Sing America alumni (over 400 hours of such interviews). She spent weekends and nights over a three-year period work- ing on the documentary.
Once the documentary was completed, Mona began marketing it at film festivals. At some of these festivals, her documentary received awards. At the same time, she developed a business plan, hired a bookkeeper to manage the finances, and hired an accounting firm to provide tax advice.
During this three-year period, she reported the following losses:
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2012
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$30,000
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2013
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400,000
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2014
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200,000
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On her tax returns for the three-year period, she offset these amounts against her law firm income of approximately $1 million in each year.
Upon audit by the IRS, the agent concluded that her filmmaking activity is a hobby and therefore the losses cannot be deducted except to the extent of the income generated.
Who is correct? Explain.