Business or Hobby?

You might not think there would be a lot of confusion deciding what is a business and what is a hobby. The truth is there is so much difficulty telling the two apart Congress created an entire section of the Internal Revenue Code devoted to “Activities not engaged in for profit” or more commonly called the “Hobby Loss” rules.

The first test is that if an activity has made a profit in the current year and at least two other years in the past five years, it is presumed to be a for profit business.

Other factors which the IRS will consider in determining if you are engaged in a hobby or business are:

• Does the time and effort put into the activity indicate an intention to make a profit?
• Do you depend on income from the activity?
• If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
• Have you changed methods of operation to improve profitability?
• Do you have the knowledge needed to carry on the activity as a successful business?
• Have you made a profit in similar activities in the past? Does the activity make a profit in some years?
• Do you expect to make a profit in the future from the appreciation of assets used in the activity?

The distinction between hobby and business are important because a loss created by conducting a for profit business can be used to offset income from other sources. While you can deduct expenses from a hobby, those expenses are limited by the amount of income generated by the hobby meaning that for tax purposes you cannot incur a loss from engaging in a hobby.

The hobby loss rules apply to individuals, sole proprietorships, partnerships and S-corporations. The rules do not apply to other corporations such as C-corps or LLC’s that have elected to be taxed as corporations.

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