Business losses may be used to offset other income, reducing the tax you pay. This does not apply to losses from a hobby. So the key question is: what is the difference between a business and a hobby?
The hobby loss rules are a trap for business owners, especially new business owners that are losing money. This is common in the early years of a business.
The IRS is focusing more and more on hobby loss audits. Fortunately, there is a lot that the business owner can do to stay out of IRS trouble.
The Basics of the Hobby Loss Rule
The Internal Revenue Service expects businesses to make a profit. However, if a business operates at a loss, the loss may be used for tax purposes to offset other taxable income, such as wages from a job or income from another business.
Unused losses are carried forward into the future, to be deducted against future income.
It is common for businesses to operate at a loss. One only has to check the news to learn about well-known, legitimate businesses that have losses.
What is the Rule 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.
To establish profit intent, generating gross income that exceeds the claimed deductions is crucial.
The IRS regulates the deductibility of losses for activities not clearly operated for profit through hobby loss limitations. These rules emphasize the importance of demonstrating a profit motive for tax purposes.
Hobby Losses: 3 of 5 Years and Occasional Profits
The tax law applies a hobby loss test for businesses. The test looks to see if an activity earned a profit for at least three out of every five consecutive taxable years. An activity that fails this test is presumed to be a hobby.
To qualify for certain deductions, the IRS requires proof that the taxpayer is engaged in the activity with the intention of making a profit, typically demonstrated by making a profit in three out of five consecutive years.
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? Understanding the Profit Motive
The three out of every five year rule is not the only indication of a hobby under the Internal Revenue Service (IRS) hobby loss rules. The tax code provides a list of characteristics 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.
Engaging in activities with elements of personal pleasure, such as hobby-type businesses, can complicate tax deductions related to Hobby Losses. It is important to consult with a tax professional when pursuing such activities to understand the impact on the ability to claim relevant deductions and establish a profit motive.
Business versus Personal Pleasure or Recreation
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.
Keep a file demonstrating these attributes in your business. The file should also contain the taxpayer’s history of income. This file will be a valuable defense in case of an audit and will help to show that your business is engaged in for profit, and not just for personal pleasure.
What is an Example of a Hobby Loss?
The hobby loss rule is a tax provision that disallows losses for activities not engaged in for profit. If expenses from these activities exceed income, deductions may be disallowed unless the taxpayer can demonstrate a profit motive, particularly for activities engaged in over a specified number of years.
Here are a few examples of actual businesses that ran into tax trouble with 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, which can affect your adjusted gross income.
The taxpayer with a side gig that is losing 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.
Hobby losses can significantly impact your taxable income, as the IRS may disallow certain deductions if the activity is not engaged in for 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 do 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 under the Internal Revenue Code. An appropriate goal is to make a profit by year three.
The suspension of miscellaneous itemized deductions from 2018 through 2025 means that taxpayers cannot offset hobby income with associated expenses, making it crucial to classify your activity as a business.
Here are 7 practical tips to keep you and your new business out of IRS trouble:
- 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 very 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.
- Keep copies of your marketing and advertising content to show the IRS in case of an examination.
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.
You are welcome to contact our CPA office and request assistance with your tax and accounting matters. We can be reached by telephone at 678-235-5460 (Atlanta) or 773-828-0551 (Chicago). To reach us online, contact us here. You are also welcome to email me directly at gary.massey@masseyandcompanyCPA.com.
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