There's a fine line between businesses and hobbies under the federal tax code. If you engage in an unincorporated sideline — such as a marketing director by day and an artist on the nights and weekends — you may think of that side activity as a business and hope to deduct any losses on your personal tax return. But the IRS may disagree and reclassify the money-losing activity as a hobby.
In general, the hobby loss rules aren't taxpayer friendly. But there's a ray of hope: If you heed the rules, there's a good chance you can win the argument and establish that you have a business rather than a hobby. Here's some guidance, along with a recent example of a taxpayer who ran afoul of the rules.
Hobby Loss Rules
If you operate an unincorporated for-profit business activity that generates a net tax loss for the year (deductible expenses in excess of revenue), you can generally deduct the full amount of the loss on your federal income tax return. That means the loss can be used to offset income from other sources and reduce your federal income tax bill.
On the other hand, the tax results are less favorable if your money-losing side activity is classified as a hobby,which essentially means an activity that lacks a profit motive. In that case, you must report all the revenue on your tax return, but your allowable deductions from the activity are limited to that revenue. In other words, you can never have an overall tax loss from an activity that's treated as a hobby, even if you lose tons of money.
Moreover, you must treat the total amount of allowable hobby expenses (limited to income) as a miscellaneous itemized deduction item. That means you get no write-off unless you itemize. Even if you do itemize, the write-off for miscellaneous deduction items is limited to the excess of those items over 2% of your adjusted gross income (AGI). The higher your AGI is, the less you'll be allowed to deduct. High-income taxpayers can find their allowable hobby activity deductions limited to little or nothing.
Finally, if you're subject to the alternative minimum tax (AMT), your hobby expenses are completely disallowed when calculating your AMT liability.
Why is the hobby loss issue an IRS hot button? After applying all of the tax-law restrictions, your money-losing hobby can add to your taxable income. That's because you must include all the income on your return while your allowable deductions may be close to zero.
A Silver Lining: IRS Safe Harbor Rules
Now that you understand why hobby status is unfavorable and for-profit business status is helpful, how can you determine whether your money-losing side activity is a hobby or a business?
There are two safe harbors that automatically qualify an activity as a for-profit business:
1. The activity produces positive taxable income (revenues in excess of deductions) for at least three out of every five years.
2. You're engaged in a horse racing, breeding, training or showing activity, and it produces positive taxable income in two out of every seven years.
Taxpayers who can plan ahead to qualify for these safe harbors earn the right to deduct their losses in unprofitable years.
Intent to Make Profit
If you can't qualify for one of these safe harbors, you may still be able to treat the activity as a for-profit business and deduct the losses. How? Basically, you must demonstrate an honest intent to make a profit. Factors that can demonstrate such intent include the following:
- You conduct the activity in a business-like manner by keeping good records and searching for profit-making strategies.
- You have expertise in the activity or hire expert advisors.
- You spend enough time to justify that the activity is a business, not just a hobby,
- You've been successful in other similar ventures, suggesting that you have business acumen.
- The assets used in the activity are expected to appreciate in value. (For example, the IRS will almost never claim that owning rental real estate is a hobby even when tax losses are incurred for many years).
The U.S. Tax Court will also consider the history and magnitude of income and losses from the activity. In general, occasional large profits hold more weight than more frequent small profits, and losses caused by unusual events or bad luck are more justifiable than ongoing losses that only a hobbyist would be willing to accept.
Another consideration is your financial status — if you earn a large income or most of your income from a full-time job or another business you own, an unprofitable side activity is more likely to be considered a hobby.
The degree of personal pleasure you derive from the activity is also a factor. For example, running film festivals in lively college towns is a lot more fun than, say, working as a finance executive — so the IRS is far more likely to claim the former is a hobby if you start claiming losses on your tax returns. (See "Lights, Camera, Action: Film Festivals Classified as a Hobby" at right.)
Toeing a Fine Line
Business losses are fully deductible; hobby losses aren't. So, taxpayers will prefer to have their side activities classified as businesses. Over the years, the Tax Court has concluded that a number of pleasurable activities could be classified as for-profit businesses rather than hobbies, based on the facts and circumstances of each case. Your tax advisor can help you create documentation to prove that you're on the right side of this issue.