Taxpayers are often confused by the differences in tax treatment between businesses that are entered into for profit and those that are not, commonly referred to as hobbies. The differences are:
Businesses Entered Into for Profit: For businesses entered into for profit, the profits are taxable, and losses are generally deductible against other income. The income and expenses are commonly reported on a Schedule C, and the profit or loss—after subtracting expenses from the business income—is carried over to the taxpayer’s 1040. (An exception to deducting the business loss may apply if the activity is considered a “passive” activity, but most Schedule C proprietors actively participate in their business, so the details of the passive loss rules aren’t included in this article.)
Hobbies: Hobbies, on the other hand, are not entered into for profit, and the government does not permit a taxpayer to deduct their hobby expenses, in excess of any hobby income, on their tax return. Thus, hobby income is reported directly on their 1040, and any expenses not exceeding the income are deductible as miscellaneous itemized deductions on their Schedule A, assuming the taxpayer is not claiming the standard deduction, in which case they would be reporting income but not deducting the expenses.
So, what distinguishes a business from a hobby? The IRS provides nine factors to consider when making the judgment. No single factor is decisive, but all must be considered together in determining whether an activity is for profit. The nine factors are:
- Is the activity carried out in a businesslike manner? Maintenance of complete and accurate records for the activity is a definite plus for a taxpayer, as is a business plan that formally lays out the taxpayer’s goals and describes how the taxpayer realistically expects to meet those expectations.
- How much time and effort does the taxpayer spend on the activity? The IRS looks favorably at substantial amounts of time spent on the activity, especially if the activity has no great recreational aspects. Full-time work in another activity is not always a detriment if a taxpayer can show that the activity is regular; time spent by a qualified person hired by the taxpayer can also count in the taxpayer’s favor.
- Does the taxpayer depend on the activity as a source of income? This test is easiest to meet when a taxpayer has little income or capital from other sources (i.e., the taxpayer could not afford to have this operation fail).
- Are losses from the activity the result of sources beyond the taxpayer’s control? Losses from unforeseen circumstances like drought, disease, and fire are legitimate reasons for not making a profit. The extent of the losses during the start-up phase of a business also needs to be looked at in the context of the kind of activity involved.
- Has the taxpayer changed business methods in an attempt to improve profitability? The taxpayer’s efforts to turn the activity into a profit-making venture should be documented.
- What is the taxpayer’s expertise in the field? Extensive study of this field’s accepted business, economic, and scientific practices by the taxpayer before entering into the activity is a good sign that profit intent exists.
- What success has the taxpayer had in similar operations? Documentation on how the taxpayer turned a similar operation into a profit-making venture in the past is helpful.
- What is the possibility of profit? Even though losses might be shown for several years, the taxpayer should try to show that there is realistic hope of a good profit.
- Will there be a possibility of profit from asset appreciation? Although profit may not be derived from an activity’s current operations, asset appreciation could mean that the activity will realize a large profit when the assets are disposed of in the future. However, the appreciation argument may mean nothing without the taxpayer’s positive action to make the activity profitable in the present.
There is a presumption that a taxpayer has a profit motive if an activity shows a profit for any three or more years within a period of five consecutive years. However, the period is two out of seven consecutive years if the activity involves breeding, training, showing, or racing horses.
All of this may seem pretty complicated, so please contact the Experts at Henssler Financial if you have any questions or need additional details for your particular circumstances.
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- Email: experts@henssler.com
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Disclosures: This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
