The CEO of ABC Corporation is a dog lover. He and his spouse like cocker spaniels and have a purebred male cocker spaniel. Because of their love for dogs, they decide to breed and sell cocker spaniel pups. In the first year, they spend $25,000 building some kennels, $5,000 on veterinarian fees, $5,000 buying breeding females, and $1,000 on food and sundry supplies. By the end of the first year, they have successfully produced their first litters but have not yet sold any puppies. They would like to deduct their losses (which they calculate by simply summing all their expenditures, a total of $36,000), but they have heard something about hobby-activity loss rules. Under the IRC, for activities classified as hobbies, only losses up to any income generated by the activity can be deducted. If, however, the activity is classified as a trade or business, and the taxpayer is actively engaged in the business, the losses are deductible against the taxpayer’s other income.

a. Why might Congress distinguish between hobby activities and trade or business activities?

b. If you were writing the tax code, what rules (or tests) would you write to distinguish an activity as a hobby versus a trade or business? Explain the purpose of each rule (or test).

c. Would the CEO’s dog-breeding activity be classified as a hobby or business under your rules?

d. Refer to one of the sources listed in Appendix 2.1 to ascertain the IRC rules for classification. Would the CEO’s dog-breeding activity be classified as a hobby or business under IRC rules?

e. If the dog-breeding activity was classified as a business, how much would the CEO be allowed to deduct against his other income?