You have started a business and you aren't making a profit. You've heard that the IRS won't accept business deductions if it considers your business a hobby. But what's the truth?
For-Profit or Not for Profit?
As you might expect, the IRS distinguishes between legitimate businesses and hobby activities, for the purpose of taxes. If you are legitimately in business, you can deduct the expenses of that business and possibly take a loss if your business isn't profitable. If you are not in business to make a profit, the IRS considers your activity as not-for-profit for sport or recreation (that is, a hobby), and it says you cannot deduct expenses to get a loss to offset other income.
Many legitimate businesses start out with a loss their first few years. But the IRS expects that a legitimate business will be set up to make a profit, not just have a hobby. Unfortunately, some people start "businesses" that are really hobbies just to claim the expenses and the loss on their tax returns.
One example is an artist who wants to claim expenses as business-related. The artist (a painter, for example) must show that they are following good business practices and that they intend to make a profit.
Is This Activity a Business or a Hobby?
A legitimate business, according to the IRS, does the following:
- Has a primary purpose of "income or profit."
- Is engaged in "with continuity and regularity."
The IRS has a list of nine factors to be used in determining whether an activity is a legitimate business or a hobby:
- Whether you carry on the activity in a businesslike manner and maintain complete and accurate books and records.
- Whether the time and effort you put into the activity indicate you intend to make it profitable.
- Whether you depend on income from the activity for your livelihood.
- Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
- Whether you change your methods of operation in an attempt to improve profitability.
- Whether you or your advisors have the knowledge needed to carry on the activity as a successful business.
- Whether you were successful in making a profit in similar activities in the past.
- Whether the activity makes a profit in some years and how much profit it makes.
- Whether you can expect to make a future profit from the appreciation of the assets used in the activity.
The IRS looks at every business on a case-by-case basis, depending on the situation.
Can a Corporation Have a Hobby Loss?
Because a corporation is a separate business entity, the IRS does not recognize the "hobby loss" rules for corporations. Because S corporation profits and losses are part of personal tax returns, the "hobby loss" rules do apply.
Will the IRS Consider My Business a Hobby?
There is no place where you designate the deductions from your activity as a business or hobby. It's the IRS that determines if your activity is a business or a hobby. This doesn't happen unless the IRS makes a determination on your business, based on years in business and profitability.
What If My Business Doesn't Make a Profit?
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. The business must be substantially the same during that time. 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.
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 for this activity. So, if you started your business in January 2020, you should make this election before the end of 2022.
The advantage of making this election is that the IRS will not immediately question whether your business is for-profit or not-for-profit. 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
Intending to make a profit and be considered a legitimate business also includes good business practices such as:
- Setting up a separate business checking account
- Keeping business and personal expenses separate
- Maintaining a good business record-keeping system
- Registering the business with a state as an LLC or partnership.
- 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.
In addition to helping legitimize your business in the eyes of the IRS, these activities are important for every business.
How Do Expenses Get Deducted for a Business and a Hobby?
A business would file its taxes on a business tax return. For most small businesses, that means filing a Schedule C for business income. The net income from the business is then included on the individual's personal tax return. If your business is an LLC or partnership or S corporation, you would prepare a tax return for that business and take the resulting income over to your personal tax return.
Expenses for hobby activities may be included with other itemized deductions on Schedule A, but you may not deduct expenses in excess of income.
For more information, read this article with details from a recent tax court case about how a business that has not made a profit might still be considered a legitimate "for profit" business.