Is your Business Actually a Hobby?
Alice bakes and sells fancy “theme” cupcakes. Lou fixes small appliances and charges for his services. Since they started about five years ago, each of their endeavors has lost money or just barely covered expenses. The IRS could take notice of the business losses that each of them has been claiming on their tax returns, and look more closely.
What will the IRS find on an audit? Does one of these activities seem to be a business and the other more of a hobby? The answer is that in the tax world, the IRS or Tax Court could classify any activity as a hobby or, more precisely, as a not-for-profit activity.
Why the difference between business and hobby matters
The difference is important. A business can offset income with all ordinary and necessary expenses. Businesses can deduct operating losses against other income and even carry the losses forward to offset income in future tax years.
Hobby activities come with more limitations. Prior to the Tax Cuts and Jobs Act (TCJA), you could deduct hobby expenses as itemized deductions, but only up to the amount of hobby income you made. These deductions, along with other miscellaneous deductions, were subject to 2% of adjusted gross income limitation. Starting in 2018, miscellaneous “2%” deductions are not allowed, so hobby expenses are not deductible. Even before the TCJA, taxpayers could not deduct hobby losses.
The bottom line: Expenses, and losses, are deductible only for activities classified as a trade or business. The difference is most notable when expenses are high and losses start mounting up year after year. This is why the IRS pays attention to businesses that have several years’ worth of losses. These “businesses” may just very well be hobbies.
How to decide if the activity is a business or hobby?
Usually, the IRS assumes that if you’ve made a profit in three of the past five years, you have a “profit motive.” If you haven’t made a profit in three of the past five years, you may end up having to prove that you have a profit motive and that your business losses were due to circumstances beyond your control.
The IRS and Tax Court use these nine factors to evaluate whether an activity is a business or a hobby.
Keep in mind that this is a simple summary and that the IRS applies each of these factors specifically for each person’s situation. For help with your situation, see your tax advisor.
- How do you carry on the activity – “businesslike” operations with detailed books and records, or more informally?
- What’s your level of expertise, or your advisor’s expertise, in the business or industry?
- How much time and effort do you spend on the activity?
- What’s your expectation that assets you use in the activity may appreciate in value?
- What successes have you had in other business activities?
- What’s your history of income or losses from the activity?
- How much in occasional profits do you earn, if any?
- What are all of your other income sources?
- Does the activity entail personal pleasure or recreation?
Not all factors apply to every situation, and no one factor determines the outcome. Ultimately, it comes down to whether you can prove that you’re motivated and able to earn a profit. It’s not enough for you to want, hope, or intend to make money. You must show that it’s possible for you to earn a profit, given the nature of the activity and the way you handle it.
What about Alice and Lou?
Getting back to Alice and Lou, do they have the skills, background, and time to devote to their respective enterprises? Do they keep excellent books and records? Have they figured out why they don’t make money, and can they change anything so that they start turning a profit?
Perhaps Alice needs to invest in different equipment, charge more money, or find better ways to market her baked goods. Perhaps Lou has a full-time job and never meant for his repair activity to be anything but something to tinker with for fun and a little extra money to pay for tools that he was going to buy anyway.
The type of activity, by itself, doesn’t reveal much about whether the IRS will see it as a business or a hobby.
What about you?
Alice’s and Lou’s situations show why it’s important to do your homework and get good advice before filing a business return.
A tax and accounting professional can help you determine whether you have a for-profit business. He or she can also help you understand how the structure of your company (unincorporated business, LLC, etc.) impact your taxes and talk to you about your new quarterly estimated tax obligation and recordkeeping responsibilities.