Avoid the Hobby Loss Rules
By Colleen Kern, CPA and Jason Watson, CPA
Posted Sun, August 11, 2019
Avoiding the Hobby Loss Rules
We are living in the age of the “side hustle.” Talk to ten of your friends and colleagues, and chances are at least half of them are building a little something on the side. Side hustles can be incredible. They give you a way to outlet your passions and hopefully make a little money outside of your 9-to-5 j-o-b. However, if you don’t have a business plan, specifically a documented profit motive, your side hustle could quickly become classified a hobby by the IRS, and that doesn’t sound nearly as cool.
The Hobby Loss Rules are governed by Internal Revenue Code Section 183 and include what’s called a Safe Harbor test to determine if your business is really a hobby. It relies on how many years you report a profit versus a loss on your tax returns (Schedule C). In general, it is assumed if you have profit 3 out of 5 consecutive years, you are engaged in a for-profit activity and therefore not a hobby. If you have more years of losses, you have to prove you are involved in operations for profit, not just for fun. Don’t worry! Profit can still be fun! We are continuously amazed at what people do for a living. Amazing!
The IRS’s website has some excellent hobby loss rule resources as well, and explains how to deduct hobby expenses. Note that we said expenses and not necessarily losses. Yup! If you are deemed to have a hobby and not a business, you may still deduct the hobby expenses against the hobby revenue.
Back to the issue at hand… wanting to deduct your business losses… just like your father might have said, your actions are going to speak much louder than your words. Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit. In order to make this determination, you should consider the following factors which are detailed in IRC Section 1.183-2(b)–
- The manner in which the taxpayer carries on the activity
- The expertise of the taxpayer or his advisers
- The time and effort expended by the taxpayer in carrying on the activity
- The expectation that assets used in the activity may appreciate in value
- The success of the taxpayer in carrying on other similar or dissimilar activities
- The taxpayer’s history of income or losses with respect to the activity
- The amount of occasional profits, if any, which are earned
- The financial status of the taxpayer
- The elements of personal pleasure or recreation.
Warning: this is not an all or nothing or weighted list. The Tax Court looks at the full picture and how each factor relates to the facts as a whole. For example, are you a concrete contractor waiting for the housing market to pick back up? Are you a tech start-up developing a new product that will take 5-7 years to bring to market.
Thankfully, there are a few Tax Court cases that give us some foundation to fall back on to ensure that while figuring out the whole “How to Make a Profit” thing, that we don’t get dumped into the Hobby Loss pit of misery instead of bonafide Business Loss (which is equally miserable but at least tax deductible).
Hobby Loss Questions
Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit. Here are some questions to consider-
Does the time and effort put into the activity indicate an intention to make a profit? If you only spend a few hours here and there, this might appear more like a hobby. Keeping a quick logbook or diary listing your hours might be helpful.
Does the taxpayer depend on income from the activity? If you have another job that is your main source of income, and you do not rely on your business for your livelihood, the IRS might consider it a hobby. At some point there needs to be a detrimental reliance on the income to be considered a business.
If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the startup phase of the business? In other words, are you simply losing money to shelter other income or are you losing money for appropriate reasons? Did customers stop buying VHS in favor of DVDs, and you were invested heavily in the VHS business? Are your expenses considered start-up costs, or could they be considered daily operational expenditures which might be considered hobby expenses instead of business expenses.
Has the taxpayer changed methods of operation to improve profitability? Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business? The IRS agent will ask about the steps you are taking to attract new customers, make sales, reduce costs, improve your knowledge of the industry, etc. If you can demonstrate that you are taking the necessary actions to earn a profit such as advertising activities and conference registrations, then your actions will suggest a legitimate business.
Has the taxpayer made a profit in similar activities in the past? Does the activity make a profit in some years? The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year.
Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity? Some taxpayers are involved in businesses that purchase property in hopes of increased value upon re-sale. Businesses involved in photography, art, music rights, automobiles, stocks, etc. who can demonstrate this connection will be considered a legitimate business.
Philosophy on Hobby Loss Rules
As any politician and economist will tell you, the key to a healthy economy is the strength of small businesses. Small businesses innovate, are typically the first ones to hire and have a unique way of becoming major players in local communities. Therefore, the tax code allows you to deduct business losses from other sources of income as a way to encourage you to take the risk of starting a new business.
In the same breath, politicians and economists will also say that the deduction of expenses for a venture that is a hobby does not help the economy and in some cases the venture might be a drain on society’s resources. It makes sense that the tax benefits of running a business should only exist if you are actually trying to turn a profit.
Cannot Pass 3 out of 5 Rule
What if you cannot pass the 3 out of 5 test? Not to worry, you can still demonstrate a profit motive. Remember, the 3 out of 5 test presumes a business if there is profit. If you cannot pass the 3 out of 5 test, you are presumed by the IRS to be operating a hobby unless you can prove a profit motive.
As mentioned earlier, there are several reasons why legitimate businesses might not be able to show a profit for 3 years- some businesses take more time to materialize their profit, and others might be victims of horrible economic conditions (e.g., a concrete contractor waiting for the housing industry to pick back up). Three choices exist:
- You could go dark, and stop deducting the business losses for a couple of years (this is not our recommendation), or
- Deduct your business expenses up to the amount of your business income for a net zero affect (this is similar to gambling losses, which can only be deducted to the amount of gambling winnings), or
- Press on and make your argument during a possible audit.
Here are some suggestions for demonstrating that your business is for real and not a hobby-
Keep Good Records. The Tax Court relies heavily on your businesslike behaviors to help determine your profit motives, and one of those behaviors is record keeping. In their eyes, businesses with a profit motive maintain good records so you should track revenue and each expense with as much detail as possible. Maintain a separate checking account for your business related transactions. Were you once profitable, but are currently experiencing several years of challenging times? Be able to show your financial history beyond the five year mark.
Prove Your Advertising. How many legitimate businesses don’t advertise? Not many. So, keep copies of your advertisements, business cards, flyers, letterhead, logo artwork, etc., and all the associated expenses (web development, graphic artist fees, etc.).
Track Your Actions. Use a business calendar app or something similar to show your actions, and how they are related to your eventual profitability. Who did you meet with? What publications did you read? Do you have a mentor? What type of training are you receiving? Conferences? How many hours per week are you spending on your activity?
Be Legit. Make sure you have all the permits and licensing required for your business. Create an LLC (we can help). Register your business in local directories.
IRS Regs. Review the items listed under Internal Revenue Code 1.183-2(b), and be in compliance with those items.
Gullion v. Commissioner Summary Opinion 2013-65
One such case is Thomas Gullion (Gullion v. Commissioner, Tax Court Summary Opinion 2013-65). Gullion is a saxophonist who unfortunately had losses in multiple years in the early aughts and was being audited (boo no fun). Since Guillion had indeed failed the safe harbor test, he was put in a position of proving that he was “engaged in musical activities with the objective of making a profit within the meaning of Section 183.” No small order, but if you read the full 14-page Summary Opinion, you see that Guillion was able to layout cold hard facts that proved he was attempting to make a profit. He showed:
- He previously worked solely as a musician with no other job/income
- When he picked up another job, he continued pursuing his music career
- He organized a music festival
- He recorded 4 CDs, one of which was advertised in JAZZed Magazine
- Multiple accounting and tax documents
The Tax Court ruled in favor of Gullion because he was able to satisfy that he was engaged in a trade or business within the meaning of Section 162(a) – his activities were conducted continuously, regularly, and with the primary purpose of deriving a profit. Specifically, out of nine IRS standards, the Tax Court examined the case and found six factors weighing heavily in Mr. Gullion’s music business favor. Here are the reasons why the music man won his case:
Expertise. Mr. Gullion, who played the saxophone since age 8, and performed professionally since age 16, possessed a wealth of knowledge in the music business.
Time and Effort. Although Mr. Gullion was a full-time computer programmer, in his spare time he focused on his music career, organized the Driftless Jazz Festival, and recorded four jazz CDs. Who records CDs anymore? Aaaaahhhh, but vinyl is making a huge comeback. We digress… the time and effort argument is important. The IRS and the Tax Court want to see that you are devoted to making this venture work. They want to see long hours and the commitment to profit that other business owners exhibit.
Similar Success. Mr. Gullion had prior success as a musician, earning a living as a professional musician from 1995 to 2002.
Income History. While his music business sustained losses from 2004 to 2010, a small profit was earned in 2011. Mr. Gullion continuously made improvements to his business with every attempt aimed at earning a profit. This is key; the IRS will ask you, “what steps are you taking to increase revenue?” Advertising? Website? Look around at other successful businesses… they are looking to increase revenue and keep expenses in check… you need to do the same.
Other Income. Despite the fact Mr. Gullion’s primary job earned him a $130,000 salary, he was trying to turn the tables, making his music career his full-time occupation.
Personal Motivation. As much as Mr. Gullion enjoyed playing music, this did not preclude him from having a professional music business. The “personal pleasure” component can be a tricky one to navigate with the IRS and Tax Court.
Parks v. Commissioner Summary Opinion 2012-105
A second case, which also was won by the taxpayer, John Dalton Parks, helps us understand how to keep our businesses classified as having a profit motive. Parks is a track coach with losses spread over 2003-2010. Similar to Gullion, the IRS believed that Parks’ activity didn’t have a profit motive. Lucky for the taxpayer the Tax Court disagreed (Parks v. Commissioner, Tax Court Summary 2012-105), due to his record keeping and the facts of his case. Here are some highlights-
- He was able to establish that he had separate books and records and banking info (see… there is a reason we ask you about that)
- His background qualified him for a side hustle in training and coaching track athletes
- His activity included multiple revenue-generating opportunities
- He sought professional advice to improve operations and profit
- After seeking professional help, he increased advertising
As you can see, there is a lot to consider when trying to determine if your business activity has a profit motive. The best considerations are to keep a business plan, document your activities, keep robust accounting records, and if you need help figuring it out, consult your tax professional. We’re here to help!
As a side bar, this is Bill Bowerman… a famous track coach who was instrumental in the launching of the Nike shoe brand. Way to go Bill!
Colleen Kern, CPA is a tax professional for WCG (formerly Watson CPA Group), a business consultation and tax preparation firm, and is part of the business development team.