What is the difference between a hobby and a business?
By Jason Watson
The hobby versus legitimate business is a common question. We have written a series of KB articles on this topic as well.
Here is a quick summary- 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.
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, taxpayers should consider the following factors:
- Does the time and effort put into the activity indicate an intention to make a profit?
- Does the taxpayer depend on income from the activity?
- 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?
- 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?
- Has the taxpayer made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?
Again, the main theme is reasonable expectation of earning a profit. 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. Having said that, there is a recent Tax Court case docketed October 25 2012 showing how a taxpayer with eight consecutive years of losses was able to demonstrate that his business was trying to earn a profit.
Read the full opinion at wcginc.com/Coach.pdf.
We also encourage you to read our article on the Hobby versus Business topic- it expands on this question and answer more in depth.