Watch Out for the Hobby Loss Rules

Dream of Turning Your Passion Into a Business? Watch Out for the Hobby Loss Rules.

Like many of us, you have dreamed of turning your hobby or passion into a regular business. Something you could do every day and hopefully, with a little planning and luck, be paid for. You will not have to worry about any unusual tax headaches, other than paying your taxes, if your new business is profitable. However, if your new business consistently generates losses, watch out for the Hobby Loss Rules. The IRS may step in and claim that the business is really just a hobby, and perhaps a very expensive one at that. What the IRS is really saying by claiming that the activity is a hobby rather than a business, is that it is not engaged in for profit.

What are the practical consequences of such a claim by the IRS? In short, the answer is deductibility; net hobby losses generally cannot be deducted from your income, whereas net business losses generally can. Under the so-called hobby loss rules, you will still be able to claim those deductions that are available whether or not the enterprise is engaged in for profit (such as state and local property taxes). However, your deductions for business-type expenses (such as rent or advertising) will be limited to the amount by which your gross income from the hobby exceeds those expenses that are deductible, whether or not the activity is a for profit enterprise. Deductible hobby expenses are also subject to a floor of 2% of your Adjusted Gross Income (a specific number on your tax return), meaning that the expenses cannot be deducted unless they exceed 2% of your Adjusted Gross Income. By contrast, if the enterprise is not affected by the hobby loss rules, all otherwise allowable expenses would be deductible, even if they exceeded income from the enterprise. This can make a big difference in your tax liability.

There are two ways to avoid being subject to the hobby loss rules. The first way is to show that the business turned a profit in at least three of the last five consecutive years. This rule changes to two of the last seven years for breeding, training, showing, or racing horses, which is a hobby that the IRS has frequently audited and challenged deductions. The second way is to run the venture in such a way as to show that you intend to turn the business into a profit-maker, rather than to operate it just as a hobby. IRS regulations state that the hobby loss rules will not apply if the facts and circumstances show that you have a profit-making objective.

How can you prove that you have a profit-making objective? In general, this can be done by running the new venture in a businesslike manner. More specifically, the IRS and the courts will look to the following factors:

  • How you run the activity (for example, having a business plan, formal financial statements, etc.);
  • Your expertise in the area (and your advisers’ expertise);
  • The time and effort you expend in the enterprise;
  • Whether there’s an expectation that the assets used in the activity will rise in value;
  • Your success in carrying on other similar or dissimilar activities;
  • Your history of income or loss in the activity;
  • The amount of occasional profits (if any) that are earned;
  • Your financial status (for example, are you independently wealthy and able to fund the enterprise indefinitely or are your resources limited?); and
  • Whether the activity involves elements of personal pleasure or recreation.

None of these factors alone will sink your case and subject you to the hobby loss rules. Rather, courts have taken a holistic approach and weigh the factors in favor of finding the activity a hobby against those weighing in favor of finding the activity a business. Your enterprise should have carefully crafted and formal organizational documents and regular minutes of meetings to document that there is a clear profit-making objective. The classic hobby loss situation involves a successful businessperson or professional who starts a side business such as dog-breeding or farming. However, the long arm of the IRS can reach out in more surprising situations, such as a businessperson who starts what appears to be a bona-fide business but enjoys what he or she does and has the unfortunate luck of not being able to turn a profit.

So, if you think your business has, or will generate consistent losses, and there is any element of personal pleasure or recreation, either for you personally or from an objective perspective, then you should consider the impact of the hobby loss rules. If you think a venture of yours may be affected by the hobby loss rules, contact our Business & Taxation team to find out what you can do right now to minimize your tax risk and the headache of a long and drawn-out IRS audit.