As many taxpayers look for additional streams of income to either supplement their current earnings or to change careers and become their own boss they face a common question. The question is if they incur losses in their endeavor is it a business loss, which would be allowed as a reduction of their Adjusted Gross Income (AGI) on their income tax return, or is it a hobby loss for which there is no deduction allowed?

FACTORS TO BE CONSIDERED

The IRS generally will classify any activity that generates profits for 3 or more years in a 5 year period as a business and the losses generated in the 1 or 2 years that were not profitable would be deductible.  I say generally because if the IRS sees a $10 profit in each of 3 years and a $25,000 loss in the other two, then they most likely would not allow the losses.

While the above is a general rule, there are circumstances under which an activity may generate losses in more than 2 out of 5 years and they would still be allowable.  Per the IRS regulations “the facts and circumstances must indicate that the taxpayer entered into the activity, or continued the activity, with the objective of making a profit.”

RELEVANT FACTORS CONSIDERED BY THE IRS

The factors shown below are some of what the IRS considers when making the determination of whether an activity is a business or a hobby:

Manner in which the taxpayer carries on the activity. Does the taxpayer carry on in a businesslike manner? Are there accurate books and records? Is there a business bank account? Are evaluations periodically made in order to attempt to make the business profitable?

Expertise of the taxpayer or his/her advisors. Did the taxpayer prepare for this new endeavor by obtaining expertise in the business or did he/she utilize experts for advice. If the business is not kept in a manner that is consistent with what an expert in the field would recommend, then it may present a problem.

Time and effort expended by the taxpayer in carrying on the activity. If the taxpayer dedicates substantial time to the endeavor it is more likely to be considered a business.

Taxpayer’s success in carrying on similar activities. If the taxpayer has taken similar businesses from losers to winners in the past, that would indicate a profit motive.

Financial status of the taxpayer. If the taxpayer has little income outside of the activity, then there is a greater chance that the activity was entered into for profit.

Elements of personal pleasure or recreation. If an activity has an element of pleasure it may be more likely to be seen as a hobby, rather than a business.

CONCLUSION

This article gives a quick analysis of the relevant facts to consider when determining whether you have a business or a hobby.  These rules are not generally black and white and I encourage anyone considering reporting a loss on such an endeavor to consult with a tax expert.