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Make sure the IRS won’t consider your business to be a “hobby”

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If you run a business “on the side” and derive most of your income from another source (whether from another business you own, employment or investments), you may face a peculiar risk: Under certain circumstances, this on-the-side business might not be a business at all in the eyes of the IRS. It may be a hobby.

The hobby loss rules

Generally, a taxpayer can deduct losses from profit-motivated activities, either from other income in the same tax year or by carrying the loss back to a previous tax year or forward to a future tax year. But, to ensure these pursuits are really businesses — and not mere hobbies intended primarily to offset other income — the IRS enforces what are commonly referred to as the “hobby loss” rules.

If you haven’t earned a profit from your business in three out of five consecutive years, including the current year, you’ll bear the burden of proof to show that the enterprise isn’t merely a hobby. But if this profit test can be met, the burden falls on the IRS. In either case, the agency looks at factors such as the following to determine whether the activity is a business or a hobby:

  • Do you carry on the activity in a business-like manner?
  • 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 your control or did they occur in the start-up phase of the business?
  • Have you changed methods of operation to improve profitability?
  • Do you (or your advisors) have the knowledge needed to carry on the activity as a successful business?
  • Have you made a profit in similar activities in the past?
  • Does the activity make a profit in some years?
  • Do you expect to make a profit in the future from the appreciation of assets used in the activity?

Dangers of reclassification

If your enterprise is reclassified as a hobby, you can’t use a loss from the activity to offset other income. You may still write off certain expenses related to the hobby, but only to the extent of income the hobby generates. If you’re concerned about the hobby loss rules, we can help you evaluate your situation.

No touchdown for this coach

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“Ordinary and necessary” expenses incurred in the pursuit of a trade or business are generally deductible. But in one case, most of the expenses claimed by a married couple were denied. The husband, a high school coordinator and coach, failed to prove that costs for meals, telephone, seminars, software, “student motivation” and more were business related or related to his teaching duties. He did substantiate the costs of football equipment he provided to low income students and was allowed to deduct them. (TC Memo 2017-42)

Travel deductions denied

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Taxpayers traveling “away from home” can deduct ordinary and necessary expenses incurred in a trade or business. But when nonresident alien students at foreign universities, who participated in a summer work-travel program, deducted travel costs to and from the U.S. and certain living expenses while here, the IRS denied the deductions. The U.S. Tax Court agreed, stating that the students weren’t “away from home in pursuit of a trade or business,” so their travel and living expenses weren’t deductible. (Liljeberg, 148 TC No. 6)

IRS ruled favorably on a community cultural center’s tax-exempt issues

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The IRS has privately ruled on a number of issues with regard to a tax-exempt organization’s activities in building and operating a cultural center, including whether its operation of a coffee shop would be an unrelated trade or business, whether certain transfers would be self-dealing transactions and whether the cost of obtaining the ruling would be a qualifying distribution. The organization is classified as a private operating foundation. (PLR 201710005)