“For-Profit” Business or Hobby, Analysis of Factors 1 – 4

If the business does make a profit three out of five consecutive years (two out of seven for training, showing, breeding, or racing horses), then the facts and circumstances will be evaluated to determine if the business is “For-Profit” or hobby.  There are 9 factors to evaluate.  This blog analyzes Factors 1 – 4.

It is important to understand that neither one factor nor a majority of factors necessarily determines the outcome.  The IRS may consider other factors not listed when determining if a business is “for profit” or hobby.

Factor 1:  The manner in which the taxpayer carries on the activity
How were books and records kept?  A business would use accounting software such as QuickBooks.  This does not mean the business could not use quicken or excel.  But it should be obvious that proper accounting of the business income and expenses is consistently being done.   The IRS will evaluate other information the taxpayer is tracking.  Such as vendor and client contact information; client account balances; keeping production data on animals; statistics on the different animals being breed; or breed and racing results.

Is there a business plan? A business will have a formal documented business plan.  The business plan should include a forecast for expected business profit and details on how to achieve the forecasted profits.

What are the methods of operation?  The business is not making money.  A “For Profit” business would implement changes to improve profitability.  The changes implemented, whether successful or unsuccessful, should be documented.

What is the efficiency of operation? A “For Profit” business may hire a specialist to help improve the profitability of the business.  The owners may attend seminars that teach small business owners how to be more profitable.  The business may implement cost cutting ideas.

How was the business promoted?  A “For Profit” business would purchase advertising.  The advertising purchased would be directly related to the product or service offered by the business.  If the business depended on network marketing, the business should have documentation supporting all efforts.

Factor 2:  The Expertise of the taxpayer or his advisers
What is the expertise of the taxpayer?  Does the taxpayer have a history of doing this type of business in some capacity?  How did the taxpayer obtain the knowledge to provide the product or service offered by the business?  Prior to starting the business, did the taxpayer extensively study accepted business and economic practices for the particular type of business?

Did the taxpayer consult with experts in the field?  An industry expert may be able to help the taxpayer establish business practices to improve profitability.  The credentials of the experts should match the industry of the business.  If business advice was provided, did the taxpayer follow the advice?  If yes, the business should document the results.   If no, then a business explanation is needed on why the advice was not followed.

Factor 3:  Time and effort expended by the taxpayer in carrying on the activity
The time and effort the taxpayer puts into the business may establish a profit motive.  A taxpayer that has a full time job and works 5 hours a week on the business may not be a good indicator of a profit motive.  If the taxpayer has a full time job and works 25 hours a week on the business may be a good indicator of a profit motive.

Factor 4:  Expectation that assets may appreciate in value
The appreciation of assets such as land or real estate may compensate for business losses.  For instance, over the last 5 years the business has lost $20,000.  During the same 5 year period, the business building is worth $30,000 more than originally purchased.   This would hold true for land being used for the business.  However, if there are plans to retire on the land then there may be no expectation to sell the land to cover all the business losses.  A profit motive may not be established if there are no intentions to sell the assets.

Four Part Blog Table of Contents

  1. Tax Consequences for Determining if a Business is For-Profit or Hobby
  2. For-Profit Business or Hobby, Facts and Circumstances
  3. For-Profit Business or Hobby, Analysis of Factors 1 – 4
  4. For-Profit Business or Hobby, Analysis of Factors 5 – 9

If you return was audited due to business losses, take a deep breath and relax.  We’re here to help you.  Call ALG Tax Solutions 855-MI-Tax-Help (855-648-2943) or provide your contact information online.

IRS Circular 230 Disclosure: To the extent this writing contains advice on a federal tax issue, the advice is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed in this communication.