By Jason Watson (Google+)
This KnowledgeBase posting has been superseded by a series of KB articles on the hobby loss topic. Please click on the link below to be redirected to updated section of our KnowledgeBase-
What Is The Difference Between A Hobby And A Business?
The hobby versus legitimate business is a common question. First, the IRS suggests that incorrect deduction of hobby expenses account for a portion of the overstated adjustments, deductions, exemptions and credits that add up to $30 billion per year in unpaid taxes. So there is a bit of an incentive for the IRS to tackle this issue head on.
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:
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 start-up 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.
IRS Tax Regulation 1.183-2(b) specifically highlights nine factors-
1. Manner in which the taxpayer carried on the activity
2. Expertise of the taxpayer and his advisors
3. Time and effort expended by the taxpayer in carrying on the activity
4. Expectation that the assets used in the activity may appreciate in value
5. Success of the taxpayer in carrying on other similar or dissimilar activities
6. Taxpayer’s history of income or loss with respect to the activity
7. Amount of occasional profits (if any) that are earned
8. Financial status of the taxpayer
9. Elements of personal pleasure or recreation
No single factor controls and other factors may be considered. Also, if five factors indicate the lack of a profit objective the activity might still be deemed a business and not a hobby.
Some Philosophy Behind Deducting Losses
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.
The Easiest Way To Avoid The Hobby Label
By definition, if you are profitable 3 out of the last 5 years your activity is automatically considered a legitimate business. Essentially turning a profit is the best way to show your profit motives (sorry for stating the obvious). There isn’t a profit threshold or a percentage that the IRS is looking for. Just being profitable, even a few bucks, is going to check the profit box and count towards your three out of five years.
What If I 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 to be operating a hobby unless you can prove a profit motive.
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 recordkeeping. 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 IRS Regulation 1.1283-2(b), and be in compliance with those items. See the beginning of this article for more information.
Again, your actions are going to speak much louder than your words. The following summary of a Tax Court case docketed October 25 2012 shows how a taxpayer with eight consecutive years of losses was able to demonstrate that his business was trying to earn a profit.
Private Track Coach Deducts Business Losses for Eight Years, Court Says OK
In a proceeding brought to the Tax Court under Docket 21600-11S filed October 25, 2012, a track coach in Oregon reported consecutive losses on eight tax returns starting in 2003. The IRS examined three tax returns starting with 2006, declared the track coach’s activity a hobby and disallowed his losses.
Under tax law, when an activity is not trying to earn a profit, it is considered a hobby and not a legitimate business, and therefore a taxpayer can only deduct the losses to the extent of the earnings. This is similar to gambling- taxpayers can only deduct gambling losses to the extent of gambling winnings.
In this proceeding, the taxpayer approached his coaching in a businesslike manner by actively advertising and seeking ways to improve his business. Specifically the coach was traveling to more track meets and attempting to connect with more potential clients. He also paid for the advice and counsel of other professional track coaches.
The time and effort spent by the taxpayer was also considered. According to court documents, the track coach spent substantial time outside of his normal teaching job on the coaching activity. Further, the taxpayer’s marriage and personal life were negatively affected by the time spent, and this supported the Court’s contention that his coaching business was trying to earn a profit.
The Tax Court also determined that the expenses from the private coaching activity were not purposely used to reduce taxable income. On the contrary the taxpayer’s losses actually created a financial hardship to the coach by reducing his income for basic living expenses. Further, while the taxpayer enjoyed teaching and coaching, the activity was not based in personal pleasure or recreation.
Most tax professionals would be reluctant to allow eight years of consecutive business losses and subsequent tax deduction. Yet all these factors led the Court to label the professional track coach’s activities a legitimate business and not a hobby, and therefore his losses were allowed to be deducted.
Read the full opinion at wcginc.com/Coach.pdf.
WCG (formerly Watson CPA Group) Philosophy On Business Losses
We cannot ethically allow you to deduct continued business losses year after year unless you understand and agree with the information contained in this article. We also have a legal responsibility as paid tax preparers to follow tax laws and internal guidelines of the IRS.
Having said that, please understand that WCG (formerly Watson CPA Group) will also tenaciously ensure you are afforded all the appropriate tax deductions and allowable credits available to you.
We are all in this together!