Hobby Losses,or showing a loss in a business for many years.
Most businesses have years where they earn money and years when they lose money. If your business is perpetually losing money year after year, that loss creates a tax benefit by offsetting your other income, reducing the taxes you pay. Given this set of facts, a taxpayer is incentivized to classify just about anything as a business- doing so would mean they can take the money they would spend no matter what (business or no) and deduct it as a business expense. The reason you can’t do that is because of Hobby Loss Rules.
Hobby Loss Rules
The IRS will allow you to deduct the losses incurred from a Hobby to the extent of your income from that hobby. So, for example consider you love painting and you’ve sold a few pieces but overall you generally spend more on paint and canvases than you make on your sold artwork. The IRS won’t tax you on the sold paintings, because your expenses bring that income to zero. But, critically, the IRS won’t let you continue to deduct your paint and canvases beyond zero. You can negate the income, but can’t create negative income which would then offset your other income (from your job, retirement, etc).
If your painting was a business it would save you money on your tax return. So, why doesn’t everything you do get called a business, allowing you to deduct things you would buy anyway, business or no? Mainly because of the risk of:
Hobby Loss Reclassification
The IRS can and does audit returns, allowing them to ask for additional information and supporting documentation for any element of that return. If, under audit, the examiner determines that the business that has been showing losses and creating useful deductions for you for years is in fact a hobby, they will disallow those losses, which will have the net effect of increases your income and taxes for all years under examination. The auditor would then assess additional taxes and penalties (and interest on both of those) retroactively. This can become very expensive.
Most businesses do not report losses perpetually and doing so is what I consider a risky tax position. It doesn’t take much for the IRS to run a search of all tax returns in the country that have shown repeated business losses on their returns. So the first moral of the story here is don’t deduct your hobbies as businesses on your tax return because it creates the risk of a costly audit.
Is It a Business or Not?
Here’s where things get tricky. There are obvious hobbies where you never expect to make any money from the activity and where you are clearly taking the money you earn and using it for the pleasure of your hobby-not investing it in your business. There are also cases where things are less clear. Thankfully the IRS has provided some guidance for deciding if you are operating a business or a hobby.
3/5 rule
The major rule of thumb for IRS classification as a hobby or a business is the 3/5 rule. If your business has shown a profit in 3 out of the last 5 years, the IRS will presume it to be a business. What that means is, it will be up to any potential auditor to prove it is NOT a business. They still may succeed in doing so, especially if the profit years are showing $2 in profit and the loss years are showing $35k in losses. This rule is great if you are definitely sure you are working on this business to eventually turn reliable profits for yourself. If you are, and you have profits 3/5 of the last years, you are in a strong position to make the case you are a business, not a hobby.
Ok, what if you’re a definitely a business, but you have shown losses in 3/5 of the last years? Then you should consider:
The 9 Factors the IRS uses to Determine if a Business is a Hobby
If you are a business showing losses that may suggest a hobby loss you should continually create as much documentation as possible to show that as many of these 9 factors apply to you as possible. Documentation means excel sheets, reports, time tracking, anything that is written down on paper or in a computer as a contemporaneous (as you go) record of how a factor applies to you and your business.
They are:
(1) Manner in which the taxpayer carries on the activity.
This can mean:
Having accurate and contemporaneous bookkeeping, not just completing it at the end of the year.
Carrying out the activity in a manner “substantially similar to other activities of the same nature which are profitable” aka, operating a lot like other businesses in the same field
Changes associated with profit pursuit, aka you had a loss year and did x or y to bring about a change in the business to lead to more profit.
(2) The expertise of the taxpayer or his advisors.
This can mean:
Preparation/extensive study of the business, economic and scientific practices, or consultations with experts.
Generally preparation or consultation must also be linked to actual application of the practices learned, just studying and not implementing suggests hobby, not business unless you are attempting to develop new or better techniques.
(3) The time and effort expended by the taxpayer in carrying on the activity.
This can mean:
The amount of time you spend on the activity (especially if the activity does not have substantial personal or recreational aspects) indicate business over hobby. To use a close to home example, Accounting does not have substantial personal or recreational aspects. The fact that I spend a lot of time doing accounting suggests business, because there are no accounting clubs or hobby accountants who are just adding up numbers for the joy of it.
(4) Expectation that assets used in activity may appreciate in value.
This can mean:
That while your business is losing money overall, your equipment, land or other real estate is growing in value such that when eventually sold/realized your overall profit will exceed the year to year expenses.
(5) The success of the taxpayer in carrying on other similar or dissimilar activities.
This can mean:
If you’ve had businesses in the past in similar fields that were profitable, it strengthens your case that this business will eventually be profitable.
(6) The taxpayer's history of income or losses with respect to the activity.
This can mean:
A series of losses up front when you first start a business are less indicative of a hobby than losses later, or losses sustained for a long period. Many businesses start out losing money. The longer you lose money, the worse your case that this is a business.
Losses due to circumstances outside the control of the taxpayer like floods, theft, fires, etc are generally not an indication of a hobby loss. Aka, if you can show in a particular year that particular events lead to a particular loss, that would strengthen your case that that loss year should not be counted against you.
A series of years where you show a profit is a strong business indicator, maybe THE strongest, because if you’re showing a profit there’s nothing for the IRS to fight you about.
(7) The amount of occasional profits, if any, which are earned.
This can mean:
In reverse to the example above where showing a small profit every now and again but large losses usually doesn’t create strong evidence for a business if you generally show smaller losses and occasionally show large profits that is evidence of a business. Not a hobby. So, take a look at your loss and gain years overall, if you had losses of -9k, -$13k, -$4k and then a profit year of $100k, this is an indicator that you’re a business.
Similarly if an opportunity to earn a substantial profit in a “highly speculative venture” is possible, that would generally be a sign of a business even if losses and small profits are being shown for some time. Aka, you’d want to show the auditor that despite x years of losses, you are working towards y payday, which you have a reasonable chance of achieving.
(8) The financial status of the taxpayer.
This can mean:
If you have income from other sources, it suggests that you are using that income for your hobby, not a business.
If you have no income or very limited income from other sources, it suggests that this business is what you are planning to fund your life with, and suggests a business.
(9) Elements of personal pleasure or recreation.
This can mean:
You’ll have a harder time making a case that your luxury resort review activity that never turns a profit is a business than you would proving that your rock moving activity is a business.
You can read the actual letter of the law for these rules here: