Is it a Hobby or a Business?

Most everyone dreams of making a living from doing things they enjoy. Many successfully turn hobbies or vocations into a business. However, the IRS has a watchful eye out for taxpayers who attempt to deduct hobby expenses as business expenses. If your business is profitable, you won’t have any unusual tax consequences. Where you run afoul of the IRS is when an enterprise consistently has a loss for the bottom line. That’s when the IRS may step in and say it is a hobby and not a for-profit business.

Under the hobby loss rules, deductions are limited to the income from the activity. In addition, those deductions that would be allowed whether or not the activity is for-profit (such as state and local property taxes) are deducted first. Then, if any net income remains, expenses up to the amount of the remaining income can be deducted as a miscellaneous itemized deduction subject to a 2%-of-AGI “floor.” By contrast, if the enterprise wasn’t affected by the hobby loss rules, all otherwise allowable expenses would be deductible on Schedule C, even if they exceed the income from the enterprise.

There are two ways to avoid the hobby loss rules. The first way is to show a profit in at least three out of five consecutive years (two out of seven years for breeding, training, showing, or racing horses). The second option is to run the venture in such a way that it shows your intention of turning it into a profit-maker rather than to operate it as a mere hobby. The IRS regulations state clearly that the hobby loss rules don’t apply if the facts and circumstances show that you have a profit-making objective.

Please call my office for more details on whether your venture may be affected by the hobby loss rules.