Hobby Versus Business Testing
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.