You have started a business and you aren't making a profit. You've also heard that the IRS won't accept business deductions if it considers your business a hobby. But what's the truth?
It's important to understand the difference between a business and a hobby because a legitimate business can deduct its expenses and possibly take a loss if it isn't profitable. But if the IRS considers your activity as a hobby, you can't deduct expenses to get a loss to offset other income.
This article discusses the criteria used by the IRS for determining whether an activity is a business or a hobby.
- An activity is considered a business if it is done with the expectation of making a profit, while a hobby is considered a not-for-profit activity.
- The IRS uses a list of factors to determine whether an activity meets the criteria of a business, making determinations on a case-by-case basis.
- If the IRS determines that an activity is not-for-profit (a hobby), its expenses can't be used to reduce other income for tax purposes.
- As of 2018, hobby income can't be deducted as a miscellaneous expense.
How To Tell If You Have a Business or a Hobby
The IRS distinguishes between legitimate businesses and hobby activities for the purpose of taxes. The agency considers a business as a for-profit entity, and a hobby activity as a not-for-profit activity. According to the IRS, a legitimate business has a primary purpose of "income or profit" and is is engaged in a profit- or income-seeking activity "with continuity and regularity."
IRS Nine Factors Test
The IRS has a list of nine factors to be used in determining whether an activity is a legitimate business or a hobby, considering each case on its own merits:
- Do you keep good business records, have a business checking account, and generally run your activity like a business?
- Do you put time and effort into marketing and other activities to bring in customers?
- Do you depend on the income from this activity for your livelihood?
- Are your business losses beyond your control or typical startup losses?
- Do you make changes in your operations to improve your profits?
- Do you have business expertise and hire competent business advisors?
- Have you been successful in similar businesses in the past?
- Do you make a profit in some years and how much?
- Can you expect to make a profit in the future?
Some types of income have greater potential to be hobbies and the IRS looks at them more closely. These activities include fishing, craft sales, dog breeding, horse racing, photography, and writing.
There is no place on your tax return where you designate the deductions from your activity as a business or hobby. You claim deductions on your business tax return for a year, and the IRS determines if your deductions can be allowed as the result of an audit.
Business vs. Hobby Rules for Business Types
Small businesses formed as sole proprietorships, partnerships, or limited liability companies (LLCs) are subject to these business-vs-hobby rules. S corporation profits and losses are part of their owner's personal tax returns, so hobby loss rules do apply to S corp owners, Corporations are separate business entities, so hobby-loss rules don't apply.
How To Deduct Expenses as a Business or Hobby
A business owner of a for-profit business can deduct ordinary and necessary business expenses in full. If the business has a loss, it can be taken to offset other income on the owner's personal tax return.
In the past, hobbyists could deduct expenses up to the amount of their hobby income, but no more. Beginning with the 2018 tax year, the Tax Cuts and Jobs Act eliminated the ability of hobbyists to deduct non-business expenses as miscellaneous expenses on Schedule A of Form 1040. The owner must still report the hobby income on their tax return.
Postponing IRS Determination on Your Business Case
You may want the IRS to postpone making a determination on whether your activity is for-profit or not-for-profit by making an election to give you a longer time to make a profit. Use Form 5213 for this purpose. You should make this election within three years after the due date of your return for your first tax year you engaged in this activity. So, if you started your business in January 2021, you should make this election before the end of 2023.
The advantage of making this election is that the IRS will not immediately question whether your business is for-profit or not. It gives you two more years to show a profit. But, if you don't have the required years of profit, the limit can be applied retroactively to any year with a loss in the five-year period.
How To Improve Your Position as a For-Profit Business
To be considered a legitimate business, it will help if you can show that you are following good business practices like:
- Setting up a separate business checking account
- Keeping business and personal expenses separate
- Maintaining a good business record-keeping system
- Registering your business with a state as an LLC
- Complying with other state and federal tax laws, including collecting sales taxes and paying annual state business renewal fees or franchise taxes
- Having regular business hours or maintaining a business website
Frequently Asked Questions (FAQs)
How many years of losses can I have before the IRS declares my business a hobby?
The IRS presumes an activity to be a business (to be set up to make a profit) if it has a profit in at least three of the last five years. But what if it doesn't? The IRS can review your business situation and make a determination on whether it's for-profit or not-for-profit.
Other factors can be considered, like whether you operate in a business-like manner, doing marketing and promotion to encourage sales, and whether you depend on the profits for your livelihood. Each situation is reviewed on a case-by-case basis.
How do I calculate AGI for a hobby loss?
Adjusted gross income (AGI) is gross income on a tax return minus adjustment. It includes wages, dividends, capital gains, and business income. When you file your business tax return for the year, the IRS may audit it if they have a question about its purpose (legitimate business or hobby). If the IRS determines that your activity is a not-for-profit (hobby) activity, you can't take deductions from that income to offset other income to calculate your AGI. You must still report the income you received from this activity.
Before 2018, you could deduct these expenses on Schedule A of Form 1040 as miscellaneous deductions, but the 2017 Tax Cuts and Jobs Act removed this deduction.
How often does the IRS audit to see whether an entity is a business or a hobby?
There's no definite timetable for this type of tax audit, and the IRS only audits if it has concerns about the activity (legitimate business vs. hobby). Some audit triggers might be:
- If the activity has large expenses with little or no income
- If losses are being used to offset other income on the tax return
- If the activity results in a large benefit to taxpayer
- If past years don't show any profits
The auditor will look at the nine factors that separate business and hobby activity and consider them on a case-by-case basis.