HOBBY LOSS RULES: WHAT TO DO?

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HOBBY LOSS RULES
Posted by: Gary Massey

With the job market in tatters in 2020, small businesses are popping up all over Atlanta.

However, hobby loss rules are a trap for new business owners.   Fortunately, there is a lot that the new business owner can do to stay out of IRS trouble.


The Basics


The IRS expects businesses to make a profit.  Nevertheless, if a business operates at a loss, the loss is generally deductible to the owners of the business.  However, businesses that generate losses year after year are red flags to the IRS.  What is the IRS thinking?  That you may be operating a hobby for personal enjoyment, rather than running an actual for-profit business.

The IRS expects businesses to earn a profit for at last three out of every five years.   A business that does not meet this profit threshold is presumed to be a hobby.    Profits from hobbies are taxable, just like any other income.    However, losses from hobbies are strictly limited by the “hobby loss rules.”


Do You Have a Hobby?


What is the difference between a hobby and a business?  According to the tax code, people own businesses to make a profit.   On the other hand, hobbies are for fun or entertainment.  There is no profit motive in a hobby.

The following factors are evidence of a business, rather than a hobby:

  1. The owner maintains complete and accurate books and records.
  2. Time and effort is put into the activity to make it profitable.
  3. The owner depends on income from the activity for a livelihood.
  4. Losses are due to circumstances beyond the taxpayer’s control.  Alternatively, losses are normal for the startup phase of the business.
  5. Methods of operation are alternated as necessary to improve profitability.
  6. The owner has the required knowledge to carry out the activity as a successful business.
  7. The taxpayer was successful in making a profit in similar activities in the past.
  8. Whether the activity makes a profit in some years and how much profit it makes.
  9. It is reasonable to expect a future profit from the appreciation of the assets used in the activity.

Losses and Expenses


The hobby loss rules prohibit taxpayers from deducting net losses generated by a hobby against wages and other income.

Prior to 2018, expenses from a hobby were allowed as a miscellaneous itemized deduction on Schedule A of a personal tax return.   Currently, deductions for hobby expenses are no longer allowed at all, even to offset hobby income.


Strategy for The Side Gig


New businesses often have losses in their early years.  Taxpayers should not worry about deducting losses from their business in the first two years.  Losses are normal and expected.  However, if losses continue into year three and beyond, the IRS may challenge these deductions as hobby losses.

The taxpayer with a side gig that is hemorrhaging money needs to evaluate if it is going to turn the corner any time soon and start making money.  If not, the business may not be viable and it may be better to shut it down.  Or, at the very least, cut back on expenses so the business makes a modest profit.  Don’t be overly aggressive.   Especially in year three of a new business.  Otherwise, the IRS may disallow the losses from the business as a hobby loss.

Keep in mind that the hobby loss rules due not apply to losses from rental properties.


5 Tips to Turn Your Hobby Into a Business


If you want to turn your hobby into a business, you need to run it in a business-like manner to avoid the hobby loss rules.  An appropriate goal is to make a profit by year three.

Here are 5 practical tips to keep you and your new business out of IRS trouble:

1. Open a separate bank account
2. Keep accurate accounting records. QuickBooks Online is a popular software used by millions of small businesses.
3. Make sure to pay your taxes quarterly.
4. Keep receipts
5. Track your auto mileage.  MileIQ is a great app that you can use.

Massey and Company CPA in Atlanta has the resources and experience to help taxpayers report their income correctly.

By Gary Massey, CPA

Founded by Gary Massey, CPA, Massey and Company is a boutique CPA firm is located in Atlanta, GA serving the needs of small businesses and their owners.

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