If the IRS decides that your business is actually a hobby, its losses are classified as “hobby losses” and may not be deductible, even against that year’s income from the hobby.
In today’s economy, it is not unusual to have more than one source of income. Sometimes these additional income sources are to supplement wages from an employer, while others result from a business owner trying to broaden the scope and reliability of the income they are receiving. Not every attempt at generating additional income generates profits, at least in the early years.
The IRS uses the Hobby Loss Rules to target businesses that present losses over three or more years, and that have a high probability of personal benefit and a low probability of profit. Examples of the latter are things like horse racing, small animal breeding, boat rental, and dealing in collectibles. The rules can also apply to any kind of business that does not make a profit, especially if losses are being funded by another business (or wages from a high-paying position).
To prevent the IRS from classifying a budding business as a hobby, and therefore disallowing the losses and/or all expenses, it’s important to understand the 9 factors that courts have determined show an owner has a business intent. Failure to make a profit does not mean that the endeavor is a hobby.
These nine factors are:
- Business-like manner: Keep copious records of expenses, sales, contracts, potential clients, industry connections, and especially marketing efforts. Draft a written business plan, revise it to include new strategies informed by those records, and update it as the business develops. While a business owner may feel like there is nothing to show for frustrated efforts, a record of those can be compelling, such as correspondence with potential clients, trade conferences that were attended, advertising, or changed plans.
- Expertise: Obtain education relevant to the business. This can include prior education that led to the business owner’s interest in the field and on-the-job training, including industry conferences and subscribing to industry publications. Hiring advisors that are experts either in the field or in business/finance can also demonstrate this, whether they are consultants or employees (even if their advice has turned out to be bad or if the taxpayer has good reason to depart from it).
- Time and effort: Log the work. Most business owners put an incredible amount of time and energy into their businesses, but it often goes unrecorded. Keep a calendar of days traveling for business, days on site, and days at conferences and meetings. If that is impractical, keep a sporadic diary recording projects and accomplishments, even if they did not generate business. When a business is growing, months can be spent working on a strategy that is abandoned; that work should be memorialized, not forgotten.
- Appreciating assets: Keep a record of assets’ changes in value, especially if the industry is volatile. If the value of a business’s asset fluctuates substantially, and then is sold at a loss, demonstrating that it had previously appreciated will support a for-profit motive. Because IRS exams can occur years after business activity, it may become difficult to document those assets sold at a loss had previously appreciated and showed promise.
- Success in other activities: Keep a resume of entrepreneurial activities. While this factor is ostensibly about past “success” in practice it is more about establishing a track record of entrepreneurial intent, so include all past attempts at entrepreneurship in any role in any field, regardless of success. This is particularly important if the business is a “side hustle” that might otherwise look like a hobby; a string of side-hustles can show entrepreneurial intent.
- History of income and loss: Keep a record of external events that impacted profitability. The Treasury Regulation specifically contemplates that continued losses can result from “drought, disease, fire, theft, weather damages, other involuntary conversions, or depressed market conditions.” Some businesses can suffer from multiple such events, and some businesses simply have a long start-up period, such as five to ten years.
- Occasional profits: Keep a record of unrealized opportunities to make a significant return on any investments. If the business receives an offer to purchase an asset, such as IP, real estate, or chattel, make a record of the offer and the reason for declining it. Turning down an offer to sell at a profit because one has a business plan to further increase or leverage the asset’s value may demonstrate a profit motive, despite future loss. Such records can also serve as evidence that the business is a “highly speculative venture” and therefore undertaken with a motivation to earn large profits despite a low likelihood of success.
- Financial status: Record the owner’s personal financial motivation for engaging in the business. For example, if the owner’s income from other activities is variable, insecure, or illiquid, that will support the owner’s profit motive, even if the owner’s financial picture is strong in retrospect. A particular financial goal, such as setting up one’s child in a business, can also be persuasive. This is particularly important if the business is a “side hustle” that might otherwise look like a hobby financed by the owner’s primary business.
- Personal pleasure or recreation: Create boundaries between the owner’s activities on behalf of the business and personal activities. Avoid having the business make personal purchases. Logging the owner’s work will also help. Keep a record of aspects of the job that might appear unpleasant to the average person, such as when it requires dirty or dangerous work, grunt work, or hands-on management. Business owners often overlook the sacrifices they make day-to-day in their passion for their work, but that dedication shows a for-profit motive.
While the IRS may believe that a business that provided personal pleasure and/or fails to make a profit is possibly a hobby and not a business, the courts have used the above nine factors as indicators that activities were business, and not hobbies, in the past allowing owners to keep their loss and expense deductions…even when no profit was shown.
As the courts see it, making a profit is less important than an intent to make a profit. Proving intent is done using the nine factors shown above.