Is my activity a business or a hobby? Tips to prevent disallowed losses.

Posted by Mike Abernathy

Business Hobby Classification - Delaware Tax Planning Taxpayers need to be careful when operating a business with consecutive losses. There is a possibility the IRS could deem your business a “hobby” and disallow your losses from offsetting other income – which could create a much higher tax bill than expected. Knowing the ins and outs of hobby loss rules could save you an expensive headache.

IRS rules state a taxpayer may only deduct losses from activities whose purpose is generating a profit. As long as the activity produced a profit in 3 out of the last 5 years (including the current year), the activity is presumed to be carried on for a profit. The only exceptions to this rule are horse breeding activities; in that scenario you only need to have a profit in 2 out of the last 7 years. If your activity fails this requirement and you deduct losses from the activity, you may be audited. However, all is not necessarily lost in this scenario; you will just have to prove to the IRS the activity really was engaged in for profit.

When the IRS is deciding on the status of an activity, it generally considers individual circumstances with each case. Here are a few key factors that the IRS might consider:

  • How much time and effort do you invest into the activity?
    • If you put a great deal of your time towards the activity, it indicates to the IRS that you intend to make a profit.
  • Do you depend on income from the activity?
    • If the activity makes up a significant portion of your income, then the IRS will be more likely to believe you’re in it for a profit.
  • Are the losses due to circumstances beyond your control?
    • If there were industry-specific issues that hampered your activity or unforeseen events that led to losses it could strengthen your case.
  • Have you changed methods of operation to improve profitability?
    • An attempt to address your losses by changing operating methods would be a strong indication to the IRS that you intend to make a profit from the activity.
  • Do you possess the necessary knowledge to carry out a successful business in this activity?
    • Having an expertise or some form of training in the activity gives credibility to a claim of profit-generating intentions.

Photo by Andrea Goh (License)


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