Unlike many important terms that are defined either in the IRC or Treasury Regulations, the term “trade or business,” which comes up throughout the IRC and regulations, has never been objectively defined. Just a few of the more than 500 sections of the IRC where the “trade or business” phrase is present include: the deductibility of business expenses [under IRC section 162(a)]; the exclusion from income for the cancellation of debts for both real property businesses [section 108(c)(3)(A)], as well as for qualified farm businesses [section 108(g)(2)(A)]; the business interest deduction limitation [section 163(j)]; the qualified business income (QBI) deduction [section 199A(b)(1) (A)]; the passive loss limitation rules (section 469); and business start-up expenditures (section 195).

It is important to have an objective definition of a trade or business to provide clarity for both taxpayers and the IRS when determining, for example, when a particular deduction or income exclusion for an activity is available to a taxpayer if it is based on a trade or business classification for that activity. Having a set of objective standards in place will help prevent uncertainty and, ultimately, litigation, which up to now has been the primary driver for the loose definitions of a trade or business.

This article will present a “one-size-fits-most” blueprint—with room for necessary tailoring—for Congress and the IRS to promulgate practical and long-overdue statutory and regulatory definitions of a trade or business for the purposes of federal tax law—with a particular focus on the IRC section 199A qualified business income deduction for real estate rental activities.

The Qualified Business Income Deduction—Trade or Business Definition Still Needed for Real Estate Rentals

The enactment of the Tax Cuts and Jobs Act of 2017 (P.L. 115-97) created the qualified business income (QBI) deduction, which is applicable to certain individuals, estates, and trusts through tax years beginning before December 31, 2026 [IRC section 199A(i)]. Qualified taxpayers may be able to take a deduction of up to 20% of QBI attributable to their ownership in a qualified business entity [IRC section 199A(b)(2)(A)]. A qualified business entity encompasses most legal business entities except subchapter C corporations (and business entities elected to be taxed as a C corporation). In addition to non-subchapter C corporations, the QBI deduction can also be generated from certain qualified real estate investment trust (REIT) dividends and from certain publicly traded partnership income pursuant to section 199A(b)(1)(B).

One of the core requirements to claim the QBI deduction is that the income comes from an IRC section 162 trade or business [section 199A(b)(2)(A)]. For businesses such as grocery stores or gas stations, there is little question that these types of activities rise to the level of a section 162 trade or business. But one of most discussed issues since the QBI deduction came into existence is whether a rental real estate activity can rise to the level of a section 162 trade or business. With millions of individuals, estates, and trusts owning rental real estate, there was originally quite a bit of concern of whether or not certain real estate activities could generate the QBI deduction for qualifying owners under the TCJA. Fortunately for many (but not all) real estate lessors, the IRS subsequently provided guidance through a set of safe harbor rules, whereby a rental real estate activity (which, under certain restrictions, multiple pieces of real estate can be combined into a real estate “enterprise”) will be deemed to have met the section 162(a) trade or business requirement based primarily on total qualifying rental service time in the rental enterprise by the owners, employees, and even independent contractors.

The first safe harbor rule was put in place by IRS Notice 2019-07 [2019-9 IRB]. Guidance was later finalized in Revenue Procedure 2019-38, which made some changes from this notice. Revenue Procedure 2019-38 generally provides that if a qualifying taxpayer (including through their employees and independent contractors) spend 250 or more hours per year in qualifying rental services in at least three out of five tax years (ending with the current tax year), the real estate enterprise will automatically be deemed to have risen to the level of an IRC section 162 trade or business; for those real estate enterprises in existence less than four years, the taxpayer has to meet the 250-hour threshold for that particular year [Revenue Procedure 2019-38, section 3.03(B)].

Even for taxpayers who do not meet the 250-hour safe harbor test, or who do not qualify for the safe harbor test—for example, if the taxpayer has lived on the property for more than 14 days during the year [section 3.05(A)]—or if there is a triple net lease in place, whereby the property taxes, insurance, and maintenance of the property is the responsibility of the lessee/tenant [section 3.05(B)], a real estate enterprise can nevertheless still potentially qualify its owners for the QBI deduction if the enterprise “otherwise rises to the level of a trade or business” [Treasury Regulations section 1.199A-1(b)(14) and Revenue Procedure 2019-38, section 1].

The preamble to the final QBI regulations (Treasury Regulations section 1.199A-1 through 1.199A-6) that were released on February 8, 2019, covered some of the potential non–safe harbor criteria that could be used to determine whether a real estate rental activity rises to the required level of a trade or business. TD 9847 states the following:

In determining whether a rental real estate activity is a section 162 trade or business, relevant factors might include, but are not limited to (i) the type of rented property (commercial real property versus residential property), (ii) the number of properties rented, (iii) the owner’s or the owner’s agents day-to-day involvement, (iv) the types and significance of any ancillary services provided under the lease, and (v) the terms of the lease [for example, a (triple) net lease versus a traditional lease and a short-term lease versus a long-term lease].


Additional points included in the preamble to the final section 199A regulations also include the following important items:

Property leased under a triple net lease … would not be eligible under the proposed safe harbor. [and]

The Treasury Department and IRS recognize the difficulties taxpayers and practitioners may have in determining whether a taxpayer’s rental real estate activity is sufficiently regular, continuous, and considerable for the activity to constitute a section 162 trade or business.


Current Case Law and Other Authority

As mentioned above, the IRC does not objectively define what is a trade or business in section 162, nor do the Treasury Regulations. Case law provides almost all of the guidance in this arena—case law that has varied substantially over the years and does not provide much in the way of specific, objective criteria. Of the numerous federal tax cases that have some relevance on the definition of a trade or business, the one that is often cited by other cases, is the focal point in business tax courses, and is even cited in TD 9487, is the Supreme Court’s decision in Comm’r v. Groetzinger [480 U.S. 23 (1987)]. In Groetzinger, an unemployed salesperson attempted to make a living by betting on dog races on a full-time basis—typically spending 60 to 80 hours per week in betting-related activities both inside and outside of the racetrack. The taxpayer claimed the losses he incurred in his gambling endeavors was a trade/business; therefore, the business losses were not subject to the minimum tax regime that was in effect at the time (1978). During the examination of Groetzinger’s tax return, the IRS determined that this type of activity was not in fact an IRC section 162 trade or business, based partially on the fact that Groetzinger had neither any customers or sales of goods or services, which was previously cited by the Supreme Court as a requirement in Deputy vs. Du Pont [23 AFTR 808 (1/8/1940)].

In Du Pont, the Court held that in order for an activity to constitute a “business” a taxpayer must hold “one’s self out to others as engaged in the selling of goods or services.” Surprisingly, the IRS’s position in the Groetzinger case ran counter to the Tax Court’s holding in the post–Du Pont case of Gentile v. Comm’r [65 TC 1 (10/1/1975)], wherein a profitable gambler (who bet on both horse races, sporting events, and traditional casino games) prevailed and was held not to be undertaking a trade or business and therefore the taxpayer’s winnings were not subject to federal self-employment tax. In Gentile, the primary rationale for the court’s decision was that despite Gentile’s regular and continuous gambling activities, because he did not offer any goods or services to anyone that this would preclude a trade/business classification. In the later case of Ditunno v. Comm’r [80 TC 362], however, the Tax Court ruled that a full-time horse gambling activity did in fact constitute a trade/business, based on a facts-and-circumstances evaluation that included how regular and continuous the services were in the hopes of making money as a living at a racetrack.

Turning back to Groetzinger, the Court determined that a dog race betting activity was in fact a trade/business. One of the key holdings was that an income-producing activity that is undertaken on a regular and continuous basis can rise to the level of a section 162 trade or business—even without customers or clients.

Outside of case law, the IRS has issued limited guidance on the definition of a trade or business front. In Revenue Ruling 55-258 [1955-1 CB 433], the IRS concluded that an individual who worked part-time, and unrelated to and outside of his employment spent approximately five hours per day entering various contests was not engaged in a trade or business and therefore the prize winnings were not subject to self-employment tax. This conclusion was based on a classification of the contest activity as a hobby, noting that the taxpayer acted on his own behalf in these contests and had no customers in the traditional business sense. At first glance, some might potentially argue that a trade or business for section 162 and self-employment tax purposes (section 1401) are two different areas of federal tax regimes (income tax versus self-employment tax) and therefore different criteria for a trade or business could be applied. In the Tax Court case of Wendell V. and Sharon Garrison vs. Comm’r [TC Memo 2010-261], however, the court clearly and concisely stated:

The term “trade or business” has the same meaning under section 1402(a), defining “net earnings from self-employment,” as under section 162.

(p. 1572)


A Blueprint for a Definition of a Trade or Business

Given its central core to the trade or business issue—not to mention it being referenced in other IRC sections (including section 199A)—it’s important to start at the statutory-level definition of a trade or business with the “grandmother” of all code sections in this area, IRC section 162.

The overall purpose of section 162(a) is to allow the deduction of all ordinary and necessary expenses of a trade or business, unless an expense is specifically non-deductible [such as most business fines and penalties under section 162(f)]. The best way to begin this big picture approach is with what clearly is not a trade or business activity—which historically and statutorily has been a hobby (technically referred to as an activity not engaged in for a profit), as defined in IRC section 183(c)—in other words, an activity that is not a trade or business under section 162 or a production of income activity (e.g., real estate rentals) under section 212. IRC section 183(d) includes a rebuttable presumption that, under most circumstances, an activity with profits (gross income less deductible expenses) in at least three of the five preceding tax years is not a hobby and therefore will normally be treated as a section 162 trade/business. Furthermore, although Treasury Regulations section 1.183-2(a) reiterates the IRC section 183(c) definition of a hobby activity as one that is not held to be a section 162 or section 212–based activity, Treasury Regulations section 1.183-2(b) provides nine relevant factors that can—but are not required to—be used in a facts and circumstances approach to determine whether an activity is engaged in for profit.

The nine suggested profit motive-based factors under Treasury Regulations section 1.183-2(b) are as follows:

Manner in which the taxpayer carries on the activity.

The taxpayer should conduct the activity in a businesslike manner, with proper accounting. When applicable, the taxpayer should change the activity’s operations with the desire to generate or increase profits.

The expertise of the taxpayer or his advisors.

A profit motive is indicated when the taxpayer properly prepares before commencing operations. This includes consulting with experts in the field or, if the taxpayer is already relatively knowledgeable in the area, developing improved operational techniques beyond their current level of knowledge.

The time and effort expended by the taxpayer in carrying on the activity.

A taxpayer who spends a significant amount of time in the activity is indicative of a profit motive. If the taxpayer were to quit a job, or reduce their hours as an employee or owner in another activity to devote more time to this activity, this would also indicate a profit motive. But the mere number of hours spent by the taxpayer is not a direct reflection of the level of profit motive.

Expectation that assets used in activity may appreciate in value.

Even if the activity has few to no operational profits (or even losses), if there are reasonable expectations that the section 1231 assets used in the business (such as land) will appreciate in value over time, this economic increase in wealth derived from the activity would indicate a profit motive.

The success of the taxpayer in carrying on other similar or dissimilar activities.

If the taxpayer has undertaken the same or similar lines of activity with prior success, this would indicate a profit motive for the current activity.

The taxpayer’s history of income or losses with respect to the activity.

If losses occur in the activity beyond the typical start-up period, this could indicate a lack of profit motive—unless there are unusual circumstances involved, such as a natural disaster or unusually bad economic conditions.

The amount of occasional profits, if any, which are earned.

This area generally looks at the risk/reward potential of an activity. For example, if a very large investment is needed to start and operate the activity, but the potential of making a profit is very limited, and even when profits are generated they are relatively small and outweighed by losses in other years, this would indicate a lack of profit motive. Also, regardless of the amount of capital investment, if losses are substantial in most years and any generated profits are relatively small, unless there is a reasonable expectation of a large profit down the road, that would also indicate a lack of a profit motive.

The financial status of the taxpayer.

In situations where the taxpayer does not have sufficient income being generated outside of the activity (such as an employee or an owner of another profitable activity) to sustain a reasonable living, where the taxpayer is relying on the activity for (hopeful) profits, this would indicate a profit motive.

Elements of personal pleasure or recreation.

This looks at the actual or potential personal satisfaction (including any recreational-based enjoyment) the taxpayer has in the activity. If the personal pleasure or recreational value of the activity is high, this could be (but is not always) a factor in whether the activity is operated with a profit motive. There is no direct statement or requirement in the regulations that personal recreational pleasure cannot be present alongside a profit motive, this element must be considered.

It should be noted that, under Treasury Regulations section 1.183-2(b), no single factor is determinative as to whether an activity is a hobby, and all of the facts and circumstances must be taken into account and these nine factors are just “among the factors which should normally be taken into account.”

Considering Other Factors

The above criteria from the Treasury Regulations focus on various profits-based criteria to define an IRC section 162 trade or business. This author would like to suggest another approach that should be incorporated in the trade/business guidelines: is a time-based approach, whereby the amount of services performed by the owner of the activity, the employees, and potentially independent contractors as well, would play a factor in the trade/business status of the activity. Of course, not all business owners are highly involved in the businesses themselves; some allow employees to perform most or all of the work undertaken by the business. The primary focus would be whether there is enough contribution of services with respect to the scope and size of the activity to warrant trade/business status.

To help illustrate this proposal, consider two examples where most would likely fully agree that the extent of total services provided in the activity would (or would not) clearly fit this trade/business test. First consider a traditional country fruit store, where during the year there are a dozen or so employees, each working 20-40 hours a week putting fruit and vegetables on the shelves, ringing up customers at the cash register, and performing all necessary cleaning and maintenance operations. With the thousands of collective hours of work performed by the employees, most would agree this is a business. On the other hand, consider an individual, who is a full-time engineer, also has a lemon tree in her backyard; four times each year, she picks a couple of handfuls of lemons, places them on a table outside of her home, and lets individuals pay 25 cents per lemon, which they leave in a piggy bank on the table. Most would agree that this minimal amount of time spent during the year and minimal gross income, it would be rather difficult for the homeowner to claim that she is in the “trade or business” of growing and selling lemons.

What are the clear differences between these two fruit-related activities that both generate gross income? One has significant services being rendered, while the other has an insignificant amount. Of course, not every business has thousands or hundreds of employees; many businesses have only a few employees and some have none at all if the sole proprietor performs all of the work herself. The key measuring stick should be the relative amount of hours worked in the activity in comparison to the amount of gross income (or potential future gross income) of the business. To draw an analogy to other established areas of federal tax law related to the level of services and status of an activity, consider IRC section 469 and its requirement for an activity not to be considered a passive activity for (primarily) individual taxpayers, and therefore not subject to the passive activity loss limitations [section 469(a)]. In general, section 469(h)(1) defines a passive activity as one in which a taxpayer does not materially participate, which requires involvement in a regular, continuous, and substantial basis. This set of very subjective criteria is very similar to the level of activity requirements in Groetzinger to reach the threshold of a section 162 trade or business.

The regulations under IRC section 469 provide a series of relatively objective standards to determine when a taxpayer is deemed to have materially participated in the activity. Temporary Regulations section 1.469-5T(a) provides up to seven situations wherein material participation in an activity has been met. With some limitations and exclusions, one of the following four current-year criteria must be met for an owner to be considered to materially participate in the activity:

  • More than 500 hours in the year;
  • Substantially all of the services of the activity (both by owners and employees);
  • More than 100 hours, if no other owner or employee of the business participates more than the taxpayer; or
  • More than 100 hours, if the taxpayer performs more than 100 hours in other, unrelated activities (significant participation activities) and the total participation time in this and the other significant participation activities is collectively more than 500 hours during the year.

Qualifying participation for the above-stated criteria does not include certain general management-type activities, such as reviewing financial statements on a real estate rental property with an outside paid property manager [Temporary Regulations section 1.469-5T(b)(2)(ii) and Lapid v. Comm’r, TC Memo 2004-222].

Even in situations where none of the above situations apply, Treasury Regulations section 1.469-5T(a) will still consider the taxpayer to have materially participated in the activity if:

  • They met any of the first four material participation tests in any five out of the previous ten tax years, or
  • If the activity is a personal service activity (fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor) and they met any of the first four material participation tests in any three prior tax years.

Finally, Treasury Regulations section 1.469-5T(a) has a final facts-and-circumstances test whereby, even when none of the (mostly) objective tests above have been met, the material participation test can nevertheless be met if “based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during such year.”

Fleshing out the Blueprint

Although IRC section 469 deals specifically with passive activities and its associated loss limitation rules, its set of mostly objective material participation tests can be used as a rough draft of a set of tests applicable and appropriate to the section 162 trade or business arena.

Given the various back-and-forth positions issues raised by taxpayers and the IRS, and the conclusions the courts have arrived at over the years in the ongoing effort to define what activities constitute a section 162–based trade or business, the following is the author’s suggested statutory approach to more objective definition of a trade or business:

IRC section 162 would be amended [a new subsection (b), with the current subsection (b) and subsequent subsections moving down one letter lower] as follows:

IRC section 162(b)—Trade or Business Defined.

  • Activities with Sales, Rentals, Leases or Licenses to Others. Subject to the provisions of section 183, in the case of an activity where goods are sold, rented, leased or licensed to customers or clients, or services are sold to customers or clients, the activity shall be considered a trade or business if the following apply for the year:
    • The total hours of services provided by the owner(s) and employees of the activity is more than 500 hours for the year; or
    • The total hours of service provided by the owner(s) and employees of the activity had been at least 500 hours in at least three of the five prior tax years; and
    • The amount of gross income for the activity is $10,000 or more for the year (adjusted for inflation) in sales, rentals, leases and licenses to unrelated customers in the current year or in at least three of the five prior tax years.


  • Activities without Sales, Rentals, Leases or Licenses to Others.Subject to the provisions of section 183, in the case of an activity where goods or services are not sold, rented, leased, or licensed (or planned to be sold, rented, leased, or licensed) to customers or clients (for example, dealing on one’s own account in the sales of securities and similar investments, gambling activities, or entering into contests) the activity shall be considered a trade or business if the owner(s) and employees of the activity spend more than 1,750 hours for the year in the activity.
  • Facts and Circumstances.In the event none of the conditions in paragraphs (1) or (2) have been met, an activity can nevertheless be considered a trade or business if activities performed by the owner(s) and employees of the activity are undertaken on a regular, continuous, and substantial basis during such year.

With this initial statutory framework in place, taxpayers and the IRS could normally rely on this relatively objective set of standards to determine whether or not an activity can be considered a trade or business in a given year, with two different levels of service-level requirements for situations wherein sales are made to customers (at a lower level of requirements) and in other situations wherein income is generated without sales to others (at a higher level). This runs parallel with cases that have focused on these two different types of income-generating activities; however, a facts-and-circumstances option is still available, if a taxpayer or IRS can establish that an activity should nevertheless be considered a trade or business even when the objective standards have not been met (including the gross income requirements where sales are made to customers). Regulations would also have to be added to cover various scenarios beyond ordinary operations (such as activities to related parties). As it relates to the section 199A QBI deduction, the safe harbor rules of Revenue Procedure 2019-38, with its lower 250-hour qualifying service threshold for real estate rentals, would still apply and trump the service hour requirements in this new statutory regime.

A One-Size-Fits-Most Solution

Although there is no uniform, one-size-fits-all definition of a trade or business that covers all of its uses throughout the IRC, the proposed blueprint above for a set of thresholds for meeting the trade/business status for an activity in section 162 is designed to be a “one-size-fits-most” alternative. This approach could also be custom-tailored in specific IRC sections when a pure reference to section 162 may not be fully suitable. Having a statutory (or if needed) regulatory definition of a trade or business is a long-overdue project. CPA should urge Congress or the IRS to take up such an effort in order to minimize litigation in this area as well to have a more objective set of standards for taxpayers, practitioners, and the IRS when planning for transactions, preparing tax returns, and auditing tax returns.

Joel Busch, JD, CPA, is an associate professor in the accounting and finance department at the Lucas College and Graduate School of Business, San Jose State University, San Jose, Calif.