You say Business – IRS disagrees, Hobby

Start a business in something you love?  You are making little money but that does not matter – you are enjoying the tax deduction advantages.  You can turn a seemingly expensive activity to a mini-business with a bunch of tax write-offs.  What a deal! But then the shock comes when the IRS says, “No!” you have a hobby and your tax deductions are taken away.  

Closely watched activities

The IRS takes a hard stance on activities that were started a a business but is deemed a hobby.  Some of the closely watched activities are:

– Making arts and craft
– Collections things such as stamps and/or coins
– Writing
– Photography
– Breeding, training, showing, or racing animals (Horses, dogs, etc)

All about the expenses

There is a major difference between business activities and hobby activities.  A business activity can write-off all business expenses – including expenses that create a business loss.  A hobby activity can write-off expenses to the extent of hobby income.

Business Example:  You in business of breeding horses.  You made $20,000 in income.  You have incurred $30,000 in expenses.  As a business activity, you can write-off all expenses – resulting in $10,000 loss. (20,000 – 30,000 = -10,000)

Hobby Example:  Your hobby is breeding horses.  You made $20,000 in income.  You have incurred $30,000 in expenses.  As a hobby activity, your write-offs are limited to income earned – resulting in $0 income or loss.  (20,000 income – 20,000 allowed expense = 0)

As you can see from these two examples, a business can write-off all expenses while the expenses of a hobby are limited to income earned.  This is a significant difference if the activity generates a loss year after year.

5 year and 7 year rule

The main rule determining whether an activity is a business or hobby is the 3 out 5 year rule. Any activity earning a profit in 3 out of 5 years is a business.  (Breeding, training, showing, or racing animals is 2 out of 7 years)

If the activity does not meet this requirement then the activity may be deemed a hobby.

Business Example
Year 1 – Profit
Year 2 – Loss
Year 3 – Profit
Year 4 – Profit
Year 5 – Loss
This is a business.  The activity earned a profit in 3 out of 5 years.

Hobby Example
Year 1 – Loss
Year 2 – Loss
Year 3 – Profit
Year 4 – Profit
Year 5 – Loss
This is may be a business or hobby.  The activity did not earn a profit in three out of five year.

9 Factors

If your activity does not meet 3 out of 5 year rule – or 2 out of 7 year rule – then you must consider other aspects of your business.  The IRS reviews 9 factors in determining whether an activity is a business or hobby.  1. Whether you carry on the activity in a businesslike manner.

  1. Whether the time and effort you put into the activity indicate you intend to make it profitable.
  2. Whether you depend on income from the activity for your livelihood.
  3. Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
  4. Whether you change your methods of operation in an attempt to improve profitability.
  5. Whether you or your advisors have the knowledge needed to carry on the activity as a successful business.
  6. Whether you were successful in making a profit in similar activities in the past.
  7. Whether the activity makes a profit in some years and how much profit it makes.
  8. Whether you can expect to make a future profit from the appreciation of the assets used in the activity.

If your business is incurring a loss year after year, review the 9 factors.  You can make changes to your business now to make sure your business stays a business and does not turn into a hobby.  Click here for more information on the business versus hobby rules.