Taxpayers often enjoy their hobby activity more than they do their job. In many cases, they invest a great deal of time and money, and some eventually make their hobby a full- or part-time business activity. Unfortunately, the IRS has a lot to say when it comes to the business vs. hobby decision. It’s not a problem as long as the new business turns a profit. And it may be fine as well if the business produces a loss and the taxpayer enjoys the activity — even better if the loss can offset other income. However, if the business consistently generates losses, the IRS could determine that these losses are actually nondeductible hobby losses.
Many hobby loss issues center on the weekend farmer or rancher. However, the hobby loss rules are applicable to any type of activity in which the taxpayer might engage. In any case, to escape the hobby loss taint and avoid ending up with nondeductible losses, the activity must be conducted with the actual and honest intent of making a profit.
There are generally two ways to avoid the hobby loss rules. The first is to show a profit in at least three out of five consecutive years (two of seven years for activities involving horse racing, breeding, or showing). If the safe harbor is met, the burden of proof for lack of profit motive is shifted to the IRS. The second way is to run the venture in a manner that shows you intend to turn it into a profit-making business rather than operate it as a mere hobby. The IRS regulations themselves state that the hobby loss rules won’t apply if the facts and circumstances show that you have a profit-making objective.
The best way to prove that you have a profit-making objective is to run the new venture in a businesslike manner. Specifically, the IRS and the courts will look to the following factors: how you run the activity; your expertise in the area (and your advisers’ expertise); the time and effort you expend in the enterprise; whether there’s an expectation that the assets used in the activity will rise in value; your success in carrying on other similar or dissimilar activities; your history of income or loss in the activity; the amount of occasional profits (if any) that are earned; your financial status; and whether the activity involves elements of personal pleasure or recreation.
In determining whether an activity is engaged in for profit, all facts and circumstances with respect to the activity are taken into account. No one factor is determinative. In addition, it is not intended that only the factors described above are to be considered in making the determination, or that a determination is to be made on the basis that the number of factors (whether or not listed) indicating a lack of profit objective exceeds the number of factors indicating a profit objective, or vice versa.
Please contact Martini, Iosue & Akpovi by phone at (818) 789-1179 if you have questions or want more information.