How the IRS Views Business Losses versus Hobby Losses
There is great confusion between what the IRS considers a business and a hobby. There is also the misconception that a hobby is bad when it comes to the tax code. That is not always true. A hobby has one very large tax advantage we will discuss later.
The IRS has a firm set of rules when determining if an activity is a business or hobby. The rules are straight forward. Any activity engaged in for-profit is considered a business and is allowed to deduct ordinary and necessary expenses. A loss is allowed against other income if expenses exceed income. If losses exceed all income the loss can be carried back or forward until used with certain limitations. If the activity is not engaged in for-profit, the activity is always considered a hobby.
The IRS presumes the activity is engaged in for-profit if the activity has gross income exceeding expenses for three of any five consecutive years. This three out of five year safe harbor is not a hard and fast rule. If you meet the three out of five year rule you ARE a business, not a hobby, and must pay business taxes. If you do NOT meet the three out of five year safe harbor, you can still be considered a business by the IRS, depending on the facts and circumstances, listed below with comment.
Taxes in a Business vs a Hobby
A hobby has one significant advantage over a business: the hobby does NOT pay self-employment tax. At 15.3%, this is real tax savings. All hobby income is required to be reported. Expenses are deductible up to gross revenue. Losses are not allowed.
Hobby income is reported on the front page of Form 1040, Other Income; expenses are reported on Schedule A, Miscellaneous Deductions subject to 2% of adjusted gross income. This means that you will not be able to use all your hobby expenses and to get any benefit will require you to itemize.
If your hobby has the periodic big sale, hobby rules will save you taxes. For example: you build model airplanes and every five years you sell one for a monster profit. Since hobbies are not subject to SE tax, you save big on the tax bill.
A business on the other hand can deduct all expenses regardless of gross income. Losses beyond current year income are called a net operating loss (NOL) and can be carried back three years and forward fifteen. The NOL rules have changed a lot in the past several years. Consult a tax professional on NOL rules and how they affect you.
Business profits are subject to SE tax and are 15.3%. For 2011 there is a 2% reduction in the payroll tax which reduces the SE tax to 13.3%. Either way, businesses pay more taxes on profits than a hobby.
Facts and Circumstances
If you do not have a profit in three out of five consecutive years you are precluded from claiming your activity as a business. The IRS considers several additional points when determining if an activity is a business. The factors listed below should not be considered all inclusive.
- The manner in which activity is carried by the taxpayer: If it runs like a business, looks like a business, it just might be a business. If it looks like a hobby...
- Taxpayer’s expertise in field, including advisor: Limited experience does not exclude the business option. If you repair cars in your garage, do you have training? Have you worked for a mechanic in the past?
- Time spent performing the activity: Do you work a significant part of your day on the activity? The more effort expended on the activity, the more likely the IRS will accept your claim that the activity is a business.
- Asset appreciation: Are activity assets expected to increase in value? If yes, you are more likely to have a business than hobby.
- Success: If you have had success in other business endeavors, the IRS considers this a level of experience and may grant business rules.
- Activity income/loss history: If an ongoing business has a patch of losses due to the economy, inflation, health, or other business difficulties, the business is still a business.
- Size of profits, if any: I see this with race car drivers. They want to deduct $40,000 a year for a few years and then show a $58 profit before heading into massive losses again. The IRS will not bite.
- Tax status: If you have a large income and it looks like you are claiming a business for deductions only, think again. The IRS is skeptical when losses reduce other income.
- Personal pleasure: It is unfair for the IRS to consider if you enjoy your business activities, but they do. Race car drivers and fishing tournament businesses have a real tough time convincing the IRS the activity is a profit.
You can take steps to look like a business. If the facts and circumstances add up to a business activity over a hobby, you win.
How to Look Like a Business
- Keeps good records: Use QuickBooks or an Excel spreadsheet to track your business income and expenses. Well kept records on paper also qualify. Receipts in a shoe box do not.
- Use separate bank accounts: Use a separate checking account and credit card for the business.
- Research the business activity.
- Get insurance and proper licenses for the activity.
- Have a separate phone number and office, even if a home office for the activity.
- Document planning activities for the increased profitability of the activity.
- Write a business plan: A well written and maintained business plan may provide the best protection against the IRS reclassifying an activity as a hobby.
I always remind clients that when dealing with the IRS,form over substance. This means that if you have your documentation in order, your business plan up to date, you have a better chance of winning. Regardless of your intent or efforts, if you do not keep proper records and an action plan, the IRS will look at you as a hobby.