The term "hobby loss" refers to an enterprise that is set up primarily as a hobby but which makes a little money and runs a loss. The IRS frowns upon taking these "hobby losses" on your tax return to avoid paying taxes. But what is a hobby and what is a legitimate business? If you want your business to be considered a "real" business and not a hobby, there are some things you must do from the start.
The IRS Guidelines on hobby losses include the following questions:
- 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 the taxpayer’s control or did they occur in the start-up phase of the business? The start-up phase can last several years, but there should be some progress toward profit during this time.
- Have you changed methods of operation to improve profitability? In other words, have you cut costs, increased marketing activities, and found cheaper ways to produce and sell products?
- Does the taxpayer or his/her advisers have the knowledge needed to carry on the activity as a successful business? That is, are you an expert in this area? Do you have credentials, education, and experience in the field, rather than just time spent on the hobby?
- Have you made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?
To add to this list, another factor is the structure of the business. If it is set up as an LLC, partnership, or corporation, there is more likelihood that it will be viewed as a "real" business as opposed to a hobby.
Some activities are viewed more skeptically by the IRS than others. Craft businesses are often viewed as hobbies, where a consulting business or professional firm might not be.
Finally, this statement from the IRS: "The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year — at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses." Note that the 3 out of 5 statement is a guideline, not a rule, and that all other factors must be taken into consideration.
In general, to avoid having your small business considered as a hobby and having your business losses and expenses disallowed, run the operation as a real business, under an accepted business structure, and work hard to make a profit.
Disclaimer. This article, and the information on this Guide Site, is intended for general information only. The author is not a CPA, tax attorney, or Enrolled Agent. Consult with your tax professional for information relating to your specific situation.