What do you mean my business is a hobby?

Christopher T. Schmidt | 08.03.16

You finally did it! You have set out and started a new business or you are operating a business ​“on the side.” Unfortunately, despite all the best intentions, you fail to break even and do not make a profit for several years in a row. If you are planning on deducting your business losses on your individual income tax return, the Internal Revenue Service might have a surprise for you; the IRS may classify your business as a hobby.

Why does this classification matter?

If your business is classified as a hobby, Internal Revenue Code Section 183 limits the deductions a business owner can claim on his or her individual tax return to the total amount of gross receipts associated with the subject business or enterprise. This limitation could effectively prevent you from deducting your business’ losses on your individual tax return. Depending on the size of the losses, this could also have a significant effect on your overall tax bill or refund.

What does the IRS consider a hobby?

The IRS considers any activity that is not engaged in for profit as a hobby. This definition may seem simple enough. But, how does a business owner show that his or her business is engaged in for profit?

An activity is presumed to be engaged in for profit if the activity makes a profit in at least three of the last five tax years, including the current year. Otherwise, the Internal Revenue Code enumerates the following factors as relevant to determining whether an activity is a hobby.

1. The manner in which the taxpayer carried on the activity;
2. The expertise of the taxpayer or his or her advisers;
3. The time and effort expended by the taxpayer in carrying on the activity;
4. The expectation that the assets used in the activity may appreciate in value;
5. The success of the taxpayer in carrying on other similar or dissimilar activities;
6. The taxpayer’s history of income or loss with respect to the activity
7. The amount of occasional profits, if any, which are earned;
8. The financial status of the taxpayer; and,
9. Elements of personal pleasure or recreation in the activity.

There is no bright line test for the number of factors that need to be met, but the more an activity looks like a profit-making business the better.

If you are starting a new venture or side business, keep in mind the hobby loss rules. Retaining documentation that addresses the above factors, and making a profit in at least three of the last five years, can go a long way toward demonstrating that your business is engaged in for profit, and is not subject to the hobby loss rules.

• Taxation