It can be difficult to tell whether an activity is a business or hobby based on a tax return. Some taxpayers claim expenses to offset income earned, even if they are only operating the business as a hobby. Because of this, the IRS has developed a rule of thumb for analyzing business losses. This is known as the Hobby Loss Rule. It is designed to prevent taxpayers from claiming deductions for activities run like not-for-profit hobbies.
In this article, the tax professionals at AG Tax will consider a recent tax court case, and help taxpayers to distinguish hobby and business, so that they can better plan their business to avoid the scrutiny of the IRS.
Business or hobby in the courts
A recent tax court case gives a rough idea of at what point the IRS would start to question whether the activity is truly a business or simply a hobby.
In this case, a mother and daughter started a horse-breeding activity, continued to pour money into a losing venture, did not have adequate insurance coverage in place, did nothing to improve profitability, and did not modify the business plan to reflect that they wanted to change the business environment to become profitable. The court ruled that the two individuals’ activity was a hobby because they did not conduct the activity in a businesslike manner. The losses incurred from the hobby activity were, therefore, not deductible against income, other than against the hobby income itself.
Factors in determining a business from a hobby
Many taxpayers have similar situations to the court case. The IRS lists several factors taxpayers should consider regarding for-profit business activity versus not-for-profit hobby:
• Hobby Loss Rule:
In general, a business is presumed to be a for-profit business if it reports a net profit in at least three out of five or seven years. However, a business is presumed to be a not-for-profit hobby if it reports a net loss in more than two out of five or seven years.
• Some factors the IRS may consider:
– The taxpayer must carry on the activity in a business manner,
– The time and effort the taxpayer puts into the activity indicates they intend to make it profitable,
– The taxpayer depends on the income for their livelihood,
– Activity losses are due to circumstances beyond the taxpayer’s control (or are normal in the start-up phase),
– The taxpayer changes their methods of operation in an attempt to improve profitability,
– The taxpayer and their advisors have the knowledge needed to carry on the activity as a successful business, and
– The taxpayer was successful in making a profit in similar activities in the past.
Please note that these rules apply to all entities except C corporations. The taxpayer may also elect to postpone the determination by the IRS (regarding whether the activity is engaged in for profit) by filing the proper forms. This allows an extension of the period of determination for two years.
AG Tax LLP Can Help
If you have any tax-related queries, need assistance with tax planning or filing your tax returns please contact us. Our team comprises of highly experienced tax professionals with extensive knowledge of U.S. and Canadian tax laws as well as cross-border compliance
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