Donna Genie explains how the IRS distinguishes hobbies from businesses for tax purposes. She contrasts tax treatment (hobbies: report all income but generally cannot deduct expenses; businesses: report income and may deduct ordinary and necessary expenses) and reviews IRS criteria for labeling an activity a hobby versus a business, giving an airplane-owner case study and practical steps (business plan, formal entity, advisors) to substantiate a profit motive.
If you operate a sole proprietorship and show losses, did you know that the IRS could disallow those? You want to make sure you're in a position to not have the IRS on your back and disallowing your losses. So let's talk a little bit about how hobbies work versus businesses. First, in those situations where you may have losses for several years, the IRS could construe your business as a hobby instead of a deductible business. So what's the difference between how hobbies are treated versus businesses? Well, hobbies are required to claim all their income, but they can't deduct any expenses against that income. Businesses, however, have to claim their income and can deduct the associated expenses against them as long as they are ordinary and necessary expenses. The IRS has a little checklist that they use to determine when they're in the situation and looking at hobby versus business, whether or not your business qualifies as a hobby or if it's truly a business. So let's run through the characteristics that they look for. First, recreational intent. Is this something you would do just for fun even if it wasn't part of your taxes and giving you a tax benefit? Is it something you enjoy personally? I actually had a case I represented with the IRS one time where a gentleman owned an airplane and rented a hangar and had large losses. He actually was a pilot at his full time profession, his full time job, and intended after he was done and retired to provide lessons. So he kept a plane. And the IRS looked at this and said he's doing this just for fun. He can't just show losses for having an airplane for multiple years. So they look at his recreational intent. Did he enjoy it? Was it really kind of fun? Next, lack of a profit motive. Are they trying to earn profit? Do they have any way possible that they could earn a profit? The taxpayer doesn't have to have a reasonable expectation of earning a profit from the activity and any income is incidental or minimal. That would mean it's a hobby if they don't have any profit motive. Next, occasional or irregular activity. So if you are an artist and you paint two pictures a year, you take photography from scenic views and once or twice a year you go to a show and try to sell your photos. They don't consider that a business because it's not a regular activity. Next, substantial personal enjoyment. Do you derive a lot of pleasure out of this? Is it leisure from the non economic side of the business? Own a boat and you take people out charter fishing. But you really just want to go fishing. That could be considered a hobby. Last, no formal organization. So if you're operating by the seat of your pants as a sole proprietor, I would suggest, suggest that you have a formal entity, an llc, an incorporated entity or something of that nature, where you're actually organized as a formal business and taking steps to protect yourself legally as well. In looking at the business criteria, they're going to look at the profit motive. Again, do they have a genuine intent to make a profit and how did they demonstrate that? Do you keep regular records of the business? Do you review financials? Regular and continuous activity? Again, not that we do this once or twice a year kind of thing. You are continually working to move that business forward. Expertise or experience. So do you have people that you utilize who help you on the expertise parts where you don't have the expertise in their situation? They say the taxpayer possesses necessary knowledge, skills, experience or training related to the activity and actively seeks advice from experts. So use an accountant. Do you have a business coach, perhaps something like that? Investment of time and effort. Do you dedicate significant time and effort towards the business dependence on your income? Are you dependent on earning that money in your life to support your life or do you have a full time job and this is just something you do a little on the side? So those are some of the criteria that the IRS looks at for hobby versus business. In my case where I had represented a taxpayer who had the airplane, I will tell you that the evidence that we used to help him make sure that he was able to show the IRS this was a business was that he had a business plan. He was seeking out my advice as his accountant and I was helping him keep up with that record system all year long and ask and helping him plan for the growth of his business. When he did retire. Those two primary things were what saved him thousands of dollars because he was able to deduct those business expenses until he was able to earn income. So many people use the criteria that the IRS uses. This is not an end all be all that you have to earn income three out of the past five years to prove their business. It's not that that checks a box. As a good example, Amazon didn't earn money in its first three years. It went many years before it became profitable. But you have to meet all of these other criteria along with it. That may just be what gets you in the game for an audit if there's a question. So use those tactics to help make sure to protect yourself from being classified as a hobby.
