Tax Deductions: Avoiding the IRS Hobby Loss Restrictions

Do you have a job or own a primary business, but also have another business activity on the side? If the side business generates losses, you might not be able to use those losses against other income if the IRS determines that the side business is really a hobby.

Hobby v. “Trade or business”

 

The tax rules are different for a trade or business than for a hobby.

First let’s note that the Internal Revenue Code uses the phrase “trade or business” a lot. There’s really not much of a difference, but the IRS uses it, so tax people use it too. The term just rolls off the tongue (or the keyboard) for most of us, but we’re really referring to any business activity engaged in for profit.

On the other hand, a hobby is an activity that is not engaged in for profit.

Suppose you’re a Pampered Chef representative, or you breed and sell parrots as pets, or (like me) you have a blog and make a few bucks with ads or product links to Amazon.com. Are you in a trade or business engaged in for profit, or is it really a hobby that’s not engaged in for profit?

Most people would say, Of course I want to make a profit. That’s a lot better than losing money. So, I have a business engaged in for profit.

Not surprisingly, the IRS doesn’t make it that simple. There are two ways to establish that you’re in business for a profit: the safe harbor rule, and the facts and circumstances test (facts and circumstances is another term that tax people use a lot).

The safe harbor

An activity is presumed to be carried on for profit if it has made a profit in at least three of the five years ending with the tax year in question. This is reduced to two out of seven years for activities involving horse racing, breeding, training, or showing.

Meeting the safe harbor isn’t ironclad proof of a profit motive. The IRS can still challenge that it’s a hobby based on all the facts and circumstances. They might try this if three years show modest profit, while the other two show much larger losses. However, if you meet the safe harbor, the burden of proof is on the IRS to show that it’s a hobby.

Also note that it isn’t necessary to meet the safe harbor in order to have a profit motive. Some people incorrectly read the reverse of the safe harbor, and think that if you haven’t made a profit in three of five years, the activity is presumed to be a hobby. That’s not the case. If the safe harbor isn’t met, all the facts and circumstances must be considered.

The facts and circumstances test

In Reg. §1.183-2 the IRS has listed nine factors to consider in determining whether an activity is a business or a hobby. Other factors can also be considered, but this list gives a good idea of what the IRS might look at on audit. No one factor is determinative. Doing these helps to establish that the activity is carried on for profit.

1. Manner in which the taxpayer carries on the activity: maintaining complete and accurate books and records, changing unprofitable methods to try to improve profitability.
2. The expertise of the taxpayer or his advisors: studying the accepted practices of the activity or consulting with experts on the activity and running the activity accordingly.
3. The time and effort expended by the taxpayer in carrying on the activity: more time spent on the activity helps indicate a profit motive, especially if the activity lacks substantial recreational aspects.
4. Expectation that assets used in activity may appreciate in value: it may be reasonable to expect that assets used in the activity, such as land used for farming, might appreciate in value and generate an overall profit, even though annual operations tend to generate losses.
5. The success of the taxpayer in carrying on other similar or dissimilar activities: past success in taking an unprofitable activity and turning it profitable.
6. The taxpayer’s history of income or losses with respect to the activity: Trends of smaller losses each year can help establish a profit motive. Larger loss years may have less weight if due to unforeseen circumstances beyond your control.
7. The amount of occasional profits, if any, which are earned: substantial profits earned in some years, particularly in an activity known to have high fluctuation or to be highly speculative.
8. The financial status of the taxpayer: the fact that the taxpayer does not have substantial income or capital from sources other than the activity may indicate that an activity is engaged in for profit.
9. Elements of personal pleasure or recreation: a profit motivation may be indicated where an activity lacks any appeal other than profit. I doubt there’s anyone cleaning porta-potties as a hobby, for example.

If I apply these to my own activity of personal blogging, I fail nearly every one of them. If I wanted to establish a profit motive, I could do some of the following:

• Get an employer identification number (EIN)
• Set up a separate bank account for the activity
• Keep good books and records, probably in QuickBooks
• Set up an LLC for the activity
• Hire a consultant to review my websites and make recommendations, then implement some of those recommendations
• Spend more time in the activity, and maybe keep a time diary

Doing these, there’s a good chance that the IRS would recognize a profit motive despite multiple loss years.

What difference does it make to my taxes?

The main tax difference between a hobby and a business is the ability to deduct expenses of the activity.

Hobbies

Expenses can only be deducted up to the amount of income earned in the activity. In other words, expenses can only take the income to zero. Also, expenses must be deducted in the following order (which is not beneficial to the taxpayer):

1. First, expenses that are otherwise deductible without regard to the profit motive. For example, real estate taxes paid on land used in a horse training activity.
2. Next, normal trade or business expenses other than depreciation and amortization.
3. Finally, depreciation and amortization.

So, you might be thinking that you at least get to eliminate any income from a hobby. That may not be the case. The expenses in categories 2 and 3 above are deductible only as miscellaneous itemized deductions on Schedule A subject to the 2% of AGI limitation. A taxpayer who takes the standard deduction instead of itemizing can’t deduct any hobby expenses. So, a hobby with a net loss can actually generate taxable income.

On the tax return

The income from a hobby is reported on the Other income line on page 1 of Form 1040 (line 21 in 2013).

The deductions in category 1 above are reported as they usually would be. For example, real estate taxes are reported on Schedule A, Line 6 (2013).

The expenses in categories 2 and 3 – up to the amount of income left after deducting category 1 expenses – are deducted as Other expenses in the Job expenses and certain miscellaneous deductions section of Schedule A (Line 23 in 2013).

Businesses

All ordinary and necessary expenses of a for-profit trade or business can be deducted. The deductions are not limited to income from the activity. That is, the activity can generate a net loss which can reduce other kinds of income, such as wages.

On the tax return

The income and expenses from a trade or business engaged in for profit are reported on Schedule C (Form 1040). The net income or loss from schedule C flows to Form 1040 page 1 Business income or (loss) (Line 12 in 2013).

Are there any benefits to hobby status?

The main upside to hobby income is that it is not subject to self-employment (SE) tax. SE tax is the self-employed person’s equivalent of social security taxes.

An activity which generates income but has insignificant expenses might yield better tax results as a hobby. An example would be a singer who gets paid to sing at weddings or other events, and whose only expenses were travel costs to the events. The savings in SE tax might be larger than the lost tax benefit of the travel costs.