Hobby Loss Rules: Can You Deduct Hobby Expenses in 2023?
Business losses are deductible. Hobby losses are not deductible. So the key question is: what is the difference between a business and a hobby?
The hobby loss rules are a trap for new business owners. If the IRS determines that your activity is a hobby and not a business, they will not allow you to deduct losses from that activity. The IRS is focusing more and more on hobby loss audits. Fortunately, there is a lot that the new business owner can do to stay out of IRS trouble.
The Basics of the Hobby Loss Rules
The IRS expects businesses to make a profit. However, if a business operates at a loss, the loss is generally deductible to the owners of the business. One only has to open the newspaper to learn about well-known, legitimate businesses that have losses.
Business losses, also called net operating losses, are deductible for tax purposes. That means that the business loss may be used to offset other sources of income, such as wages from a job or income from another business. Unused losses must be carried forward indefinitely, to be deducted against future income.
However, deductions for losses are not allowed for hobbies. Hobbies are not considered to be businesses at all. Multiple years of losses are the primary sign that an activity is a hobby. In fact, repeated losses, year after year, are red flags to the IRS, increasing the chance of an IRS audit.
What is the IRS thinking? Multiple years of losses suggest that your activity is actually a hobby, intended for personal enjoyment, rather than a for-profit business enterprise. And the IRS is not going to allow deductions for personal enjoyment.
Hobby Losses: 3 of 5 Years
The IRS applies a hobby loss test when examining tax returns. The test looks to see if an activity earned a profit for at last three out of every five years. An activity that fails this test is presumed to be a hobby.
And, as we have said, losses from hobbies are not tax deductible.
Nevertheless, profits from hobbies are still taxable, just like any other income. That may sound unfair, but those are the rules.
Do You Have a Business or a Hobby?
The three out of every five year rule is not the only indication of a hobby under the IRS hobby loss rules. The tax code provides a list of characterizes that are meant to distinguish between for-profit businesses and hobbies that are conducted for fun or entertainment. These characteristics focus on whether or not the activity has a profit motive and is run like a real business.
The IRS expects a business to have the following attributes:
- The owner maintains complete and accurate books and records
- Time and effort is put into the activity to make it profitable.
- The owner depends on income from the activity for a livelihood.
- Losses are due to circumstances beyond the taxpayer’s control. Losses are considered to be normal during the startup phase of a business.
- Methods of operation are modified as necessary to improve profitability.
- The owner has the required knowledge to carry out the activity as a successful business.
- The taxpayer was successful in making a profit in similar activities in the past.
- The activity makes a profit in some years. The magnitude of profit is also considered.
- It is reasonable to expect a future profit from the appreciation of the assets used in the activity.
What is an Example of a Hobby Loss?
Here are a few examples of actual businesses that ran afoul of the IRS hobby loss rules:
- Consistently unprofitable ranching activity. Williams, T.C. Memo. 2018-48.
- Club primarily for country music writers to have up-and-coming artists perform their songs. The expenses of running the club consistently exceeded the revenue from admission. Ford, T.C. Memo. 2018-8.
- Owning and racing horses, resulting in yearly losses. Carmody, T.C. Memo. 2016-225.
Strategy for The Side Gig: Avoiding a Hobby Loss
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 about expenses. Especially in year three of a new business. Otherwise, the IRS may determine that the hobby loss rules should be applied.
Atlanta CPA Note: Keep in mind that the hobby loss rules due not apply to losses from rental properties.
7 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 7 practical tips to keep you and your new business out of IRS trouble:
- Open a separate bank account
- Keep accurate accounting records. QuickBooks Online is a popular software used by millions of small businesses. Your accounting records should be reconciled on a monthly basis. This is the best way to maintain accuracy and ensure that your books are ready for taxes.
- Make sure to pay your taxes quarterly. This is super important and easy to forget. Your CPA or tax preparer will provide you with the payment amounts, due dates and instructions.
- Keep receipts. In combination with good bookkeeping and accounting, this is the best way to “audit-proof” your business.
- Track your auto mileage. MileIQ is a great app that you can use.
- Consider using an entity, such as an LLC. While this does not necessarily save on taxes, it does help to limit liability.
- Always maintain separate bank accounts for your business. Do not comingle business and personal funds.
Tax Return Preparation for Small Businesses
Compliance with the hobby loss rules is a daily part of our Tax Practice. It keeps our clients out of tax trouble.
Massey and Company CPA is a boutique tax and accounting firm serving individuals, small businesses and non-profits in Atlanta, Chicago and throughout the country. Our Tax Department provides tax return preparation, tax planning for businesses and individuals, IRS tax problem resolution, and IRS audit services. Our Accounting Department provides small business accounting and bookkeeping services using QuickBooks Online.
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