Whether a person’s business is regarded by the IRS as a hobby, where losses are not deductible, or a business, where losses are deductible, has confused many of us. There is not a clear set of rules, but there are guidelines to help make the right call.

 

First, here are some aspects of your business or hobby to ask yourself:

̶  Time and effort indicates profit motive

̶  Depend on the income from activity

̶  Losses unavoidable or in start-up phase 

̶  Operations addressed to improve profitability

̶  Owner has specialized knowledge in activity

 

Second, there is a profitability test that the IRS uses to determine if you have a business or a hobby. If you generated a profit in three or more years out of the past five years, in an audit the onus is on the IRS to prove you are not in business to make a profit. If you have less than three out of five years making a profit, the onus is on you to prove to the IRS you have a business and not a hobby. Here are three examples to help you understand what is a business and what is a hobby:

 

Gary enjoys golf. In his forties, Gary bought a field where he could set up a driving range and pro shop. He developed a business plan and quit his job. He acquired inventory, advertised, hired staff and worked long hours. By his fifth year his business was still losing money.  

 

Wendy is an attorney who enjoys working with wood. When through her father’s estate, his home, woodshop and tools passed to her, she moved in and began making custom furniture gifts for her friends and family. Soon she had all kinds of people beating a path to her door. So she haphazardly set up a business that made a net profit in two out of the last five years.

 

Fred and Faye have a dairy goat operation that Faye manages while Fred works at a job. Fred and Faye have a business plan, business bank account and keep excellent records. They had losses in two out of the past five years.

 

All three sets of folks have their income tax returns selected for an IRS audit. At issue is the business losses claimed.

 

So how does Gary fare in the audit? It looks like his activity is definitely not a hobby, even though his love of golf led to his business. If he keeps losing money he may have to close. Fred and Faye do not have anything to worrry about because they meet the profitability test and keep good records. Wendy? She does not meet the profitability test and her records are a mess. The IRS will likely rule she has a hobby which limits her tax deductible expenses to the extent of her woodworking income on her tax return.

 

Consult with your tax advisor to make sure any business losses will be tax deductible and please stay safe through this holiday season.