Is Your Hobby a Business to the IRS?
How the IRS Differentiates Between Deductible Business Expenses and Non-Deductible Hobby Costs Through the Hobby Loss Rule
It is not uncommon for successful business people and other individuals with an entrepreneurial impulse to decide that they’d like to try their hand at a side business. The reasons for this decision can vary, but typically the reasons behind this decision include elements of an interest in the underlying industry or subject matter combined with a desire to supplement one’s income. In most cases, the consulting business or side-project is launched while the founder is still engaged in his or her day job due to the fact that he or she, generally correctly, anticipates losses during the first few years of operation.
Typically the IRS will understand the fact that new business will lose money in its initial years of operation. However, the IRS also understands that the goal of setting up something that is purported to be a business is to turn a profit. If an allegedly for-profit business reports greater expenses than revenues year-after-year while the taxpayer uses this loss to reduce his or her other and potentially unrelated taxes, the IRS often detects this red flag and may seek additional information or engage in an audit of the taxpayer and his or her business.
Understanding when you can and cannot claim deductions for a side business or side activities is a key determination that every entrepreneur must make if he or she wishes to avoid potential audits and tax penalties down the line. To schedule a reduced-rate consultation with an experienced tax lawyer from the Tax Law Offices of David W. Klasing, call 800-681-1295 today.
For-Profit Business Activity, For-Profit Non-Business Activities, and Hobbies Not Engaged in for Profit
The IRS utilizes Internal Revenue Code (IRC) § 183, commonly referred to as the hobby loss rule to make determinations regarding whether an activity is a for-profit activity or a personal activity or hobby that is not intended to make a profit. While many people hastily believe that nearly any economic or quasi-economic activity they may engage in is a for-profit business, the IRS frequently makes claims and rulings to the contrary. The IRS considers a broad range of businesses and activities subject to the Hobby Loss Rule including:
- Airplane charters
- Yacht charters
- Horse breeding
- Craft sales
- Direct sales
- Online sales
- Coin and stamp Collecting
- Home brewing
- Home distillery
- Artistic activities and ventures
- Farming activities
- Fishing activities
Typically, there is a presumption that an activity is for-profit in nature when it returns a profit in three out of five years of operations, inclusive of the current year. If the presumption is operative, the IRS holds the burden of proving that the activity is not for profit or a hobby. However, even when applicable the presumption applies, it protects only the third profit year and the years thereafter falling within the five-year period.
What Rules Apply When There Is A question About the Profit Motive?
When there is a question or issue regarding the profit motive, the IRS auditor or examiner is guided by nine factors set forth by the hobby loss rule. The factors are:
- Is the operation run like a business? Relevant factors include the existence of a business plan, the existence of books and records, and the segregation of personal and business funds.
- Does the taxpayer have the requisite knowledge or skills to conduct a business operation of this type? Has the individual retained experts or made other attempts to educate themselves about running a business in this field?
- The amount time and effort devoted to the activity including the tracking of the same.
- Has the taxpayer researched market trends or have other evidence that he or she expects assets to appreciate or that capital gains will offset past losses?
- Does the taxpayer have past successes in similar or different business activities?
- What is the history of the businesses profits and losses?
- Does the taxpayer have occasional or sporadic profits?
- Does the taxpayer have substantial additional income from sources unrelated to the challenged activity?
- Is the activity typically associated with recreation or personal pleasure?
None of these activities are determinative of the analysis and they are all considered. However, since many of the factors are outside of the taxpayer’s current control, it is wise to ensure that the elements that are under the taxpayer’s ability to exercise control are likely to be determined in his or her favor.
Are There Real-World Applications of IRC § 183’s Hobby Loss Rule?
In Craig v. Commissioner, T.C. Summary Opinion 201358 the hobby loss rule was applied in the context of an individual’s claims for tax deductions relating to horse breeding activities. The taxpayer purchased a substantial amount of farm property and purchased seven horses from 2004 through 2010. To further her understanding of the care a horse requires, she stated that she consulted with local horse breeders, 4-H club members, and a horse trainer friend. Furthermore, the taxpayer spent up to 30 hours a week riding and caring for the horses.
However, the individual had no plans to sell any of the horses and commingled personal and horse breeding-related funds paying all expenses from her personal accounts. She also failed to develop a business plan or budget for these activities and did not keep business-like records.
While one might expect the taxpayer to have at least several factors in her favor, in actuality she failed all nine factors of the test. Of the more unexpected and notable failures, she failed the second factor because although she sought advice regarding horses that was consistent with her love and passion, she did not seek business-focused guidance from experts. She also failed the third factor because, without some business-like record of time spent, the substantial number of hours expended were merely consistent with her love of horses. All told, this is a cautionary lesson against simply assuming that activities that at some point could theoretically lead to a profit will be viewed as a business with a profit motive by the IRS.
What Impact on the Ability to Claim Deductions Can an IRS Hobby Loss Rule Determination Have?
The most liberal deductions for side-businesses are available through IRC§ 162 where the taxpayer may deduct on the basis of for-profit business activity and ICR § 212 where deductions are available for non-business activities engaged in for a profit.
For a taxpayer to lawfully claim deductions for expenses under IRC § 162 or § 212, the individual must be engaged in activities where the expenses relate to a legitimate profit-making intent. Keanini v. Comr., 94 T.C. 41 (1990) (citing Golanty v. Comr., 72 T.C. 411, 425 (1979), aff’g without published opinion, 647 F.2d 170 (9th Cir. 1981)). The burden to prove the prove the profit-making intent is the responsibility of the individual taxpayer. Hendricks v. Comr., 32 F.3d 94 (4th Cir. 1994), aff’g T.C. Memo 1993-396. Where there is a clear question regarding the profit-making intent of the taxpayer, the IRS will frequently disallow the deduction and force the individual to prove his or her intent. Generally, this requires a showing that the taxpayer has an honest and legitimate belief that the business will be able to turn a profit. This can be shown through the time the taxpayer devotes to the business and through projected profits and industry publications regarding the profit potential for the business. Taxpayers who are unable to sufficiently demonstrate these elements are not eligible to claim deductions through IRC §162 or §212 and will likely face penalties and interest on improper claims.
For activities that do not fit into either of these categories, less generous or no deductions are available. Activities that are not engaged in for a profit have strict limitations on allowable deductions imposed by IRC § 183. Additionally, hobbies and other personal activities are not generally entitled to deductions under IRC § 262.
Collateral Impacts of Determinations Regarding Whether an Activity Is Pursued For-Profit
While the ability to make deductions for expenses and losses incurred during the pursuit of the activity is often the foremost concern in the taxpayer’s mind, it is not the only aspect of their tax filing that is affected by a determination of this type. If the taxpayer is found to be engaged in a for-profit business activity, he or she may have an obligation to satisfy self-employment tax which can lead to significant interest and penalties. Furthermore, where IRC § 183 presents a problem, there may be alternative minimum tax (AMT) considerations that apply. In essence, there are an array of tax issues that can be affected by a hobby loss rule determination. For a comprehensive overview of the possible effects of a determination for or against you, it is wise to consult a tax attorney who can work through the scenarios with you.
Strategic Guidance and Advocacy for IRS Audits Concerning the Hobby Loss Rule
If you are considering launching a side-business while also making claims to deduct losses against your overall tax liability it is prudent to seek experienced guidance on not only this issue but also the full range of tax implications. The tax attorneys and CPAs of the Tax Law Offices of David W. Klasing can provide a step-by-step breakdown regarding how making claims of this type can potentially affect your future taxes and the potential for an audit. If you’ve already been contacted by the IRS for more information or for an audit, David Klasing is a former public auditor with more than 20 years of practice experience. He can put this experience to work for you by developing a strategic game plan to address the audit and mitigate the circumstances you face. To schedule a reduced-rate consultation, call 800-681-1295 today.