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Business vs. Hobby: Avoiding Hobby-loss Treatment

Business vs. Hobby
Avoiding Hobby-loss Treatment

Under the Internal Revenue Code (IRC) Section 183 hobby-loss rules, the deductible expenses of a hobby are limited to the amount of income the hobby generates. To avoid this limitation and to be considered a business, an activity must be engaged in for-profit activity.

Due to the elimination of miscellaneous itemized deductions in the years 2018 through 2025, deductions for hobby expenses are not allowed as enacted by the Tax Cuts and Jobs Act (TCJA).

The inability of a taxpayer to deduct even a portion of hobby expenses while recognizing hobby income makes establishing a profit motive for a hobby difficult. The determination of whether an activity is for-profit is based on the facts and circumstances; however, a statutory safe harbor is provided that, if met, causes a presumption that the activity is a for-profit endeavor.

Business vs. Hobby
What are the factors that determine if an activity is a business or a hobby? Some of the relevant questions that a taxpayer should consider include:

  • What is the motive of the taxpayer? 
  • Does the taxpayer treat the activity as a business? 
  • Are accurate books and records maintained?
  • Does the taxpayer invest the time and effort in the activity to make a profit?
  • Does the taxpayer depend on the income from the activity?

In general, if the taxpayer treats the activity as other taxpayers treat similar for-profit businesses, then it may be considered a business.  This would include maintaining accurate books and records, having a separate checking account, and adhering to accounting principles and methods.   

The taxpayer’s expertise is another factor to consider. For example, if the taxpayer is an engineer and maintains a farm, does the engineer have the agricultural expertise to maintain a for-profit farming operation?  How much time is the taxpayer devoting to this activity?  If a significant amount of time is spent on only this activity, then the activity may be considered for-profit.  However, if the taxpayer devotes minimal time to this activity and focuses on their full-time professional job, this suggests the activity is a hobby.

Has the taxpayer engaged in a similar activity in the past and did the activity generate a profit?   Are there valid reasons why the activity is not generating a profit? Has the market or economy changed?  Should the taxpayer change their methods or location?  An activity might be expected to show losses in the initial year due to start-up costs.  Some losses are beyond the control of the taxpayer such as weather damage, fire, and theft. These types of losses alone may not mean the activity is not for-profit.  A series of years where net income is realized would infer that the activity is for-profit.  

Taxpayer’s Intent
Profits in relation to losses, as well as the amount of the taxpayer’s investment and the value of the assets used in the activity, may provide useful guidelines in determining the taxpayer’s intent.  An occasional small profit from an activity generating large losses or from an activity in which the taxpayer has made a large investment, would generally not indicate a for-profit activity.  However, substantial profit, even if it’s only occasional, generally indicates that an activity is for-profit if the investment or losses are comparatively low. 

What is the financial status of the taxpayer?  If the taxpayer does not have substantial income or capital from other sources, this may indicate the activity is for-profit.  Income from sources other than the activity, particularly if the activity is generating losses, may indicate that the activity is not for-profit, but a hobby.  The presence of personal motives or recreation in an activity may also indicate that the activity is not for-profit.  An example is a vacation home rental, if the taxpayer utilizes the home more than it is rented. 

Safe Harbor Provision
Even though losses exist, the taxpayer may be able to meet the safe harbor provision.  A taxpayer meets the safe harbor if an activity generates a profit for at least three out of five years. If the activity involves horse racing, breeding or showing, then the activity must generate a profit for at least two out of seven years. If this safe harbor is met, the burden of proof for lack of profit motive is shifted to the IRS. The IRS can still challenge the profit motive presumption by proving that the activity is not engaged for-profit. If the safe harbor is met, the IRS will not attempt to rebut the presumption unless there are unusual circumstances.  The safe harbor applies only for the third profitable year and all subsequent years within a five-year period beginning with the first profitable year.  For horse racing, breeding or showing, the safe harbor applies only for the second profitable year and all subsequent years within a seven-year period beginning with the first profitable year. The  safe harbor might not be as advantageous as it might appear.  It’s is only available after the third profitable year in a five- year period.  Therefore, only losses after this time period are protected. 

While it may seem to be beneficial for the taxpayer to apply the safe harbor to the activity, there are other factors to consider.  A taxpayer may wait to determine whether the safe harbor applies until the close of the fourth tax year (or sixth tax year, in the case of horse racing, breeding, or showing) after the tax year in which the taxpayer first engages in the activity.  The advantage of this election is that losses from the activity during the five-year period are tentatively allowed during that period (as opposed to being disallowed until the activity has been profitable for three years) and reported on Schedule C. If the election is made and the activity is profitable for three or more of the five years, the activity is presumed engaged in for-profit throughout the entire five-year period. The election shifts the timing of the ability to use the safe harbor to an earlier period. However, if the election is made and the taxpayer fails the three-out-of-five-year test, the taxpayer may be faced with a substantial tax deficiency for all years involved.  Taxpayers should review their current year activity and future projections. 

Taxpayers can make a valid election, by filing Form 5213, Election to Postpone Determination as to Whether the Presumption Applies That an Activity Is Engaged in for Profit and execute a waiver of the statute of limitation. The election of Form 5213 is filed separately from the individual tax return. Filing Form 5213 automatically extends the statute of limitation for any deficiency attributable to the activity.

If you have any additional questions or wish to discuss whether your activity is a business or a hobby, please email us at info@herbein.com

Article written by Frances Benko