Hobby Losses Exam: Business or Hobby?

An area that extends beyond merely monitoring income and expenditures is the management of a hobby loss assessment. Here, you must make a determination regarding whether you possess a valid business or merely a hobby. Is it a legitimate business with numerous deductible expenses, or just a hobby with limited deductions based on hobby income?

The IRS is checking how people report their businesses. Taxpayers must know the rules about hobby losses for federal taxes, as opposed to business deductions. Do you have a hobby or business for tax purposes?

You have more at stake in this exam than your basic audit of a business run for profit. You need to question your entire business, purpose, and past actions, which means you need to prepare very differently. You need to show that the business loss that you claimed is not actually a hobby loss.

Revenue Code §162 states that to be deemed a business, one must meet the following requirements.

The taxpayer must actively engage in the activity with continuity.
The taxpayer must actively engage in the activity on a regular basis.
The taxpayer’s primary purpose for carrying on the activity must be for income or profit.

We need to make an evaluation to determine if the above requirements have been fulfilled. If the taxpayer has a hobby instead of a business, their expenses are restricted by Revenue Code §183. They can only claim expenses up to the amount of income they earn from the hobby.

Is Activity Loss a Bonafide Business Loss or Hobby Loss

The Treasury Regulation §1.183-2(b) has nine factors to decide if someone has a business loss or a hobby loss:

The manner in which the taxpayer conducts the activity.
The expertise of the activity that the taxpayer has.
How much time and effort is put forth to carry out activity.
Expectation that assets utilized in the activity may appreciate in value.
The success of the taxpayer in carrying out other activity endeavors.
The taxpayer’s past income and loss while engaging in activity.
The amount of occasional earned profits.
The taxpayer’s financial status, are there funds to support activity.
Level of personal pleasure or recreation.

Determining whether an activity is performed for profit or not, does not rely on one determinative factor. Every case will be examined, and all circumstances and factors will have an impact on the decision.

Steps to Take to Ensure Activity is a Business and Not a Hobby

There are three areas that are very evident in U.S. Tax Court decisions regarding hobby loss. These are:

The way in which the taxpayer performs the activity.
His or her expertise in the field of activity.
What changes did the business make in response to the financial results and changes in the economic climate?

With this in mind, it is essential that the taxpayer pay close attention to the following:

The taxpayer must have a detailed business plan and act accordingly. The goal of any business is to turn a profit and have a successful business.

You should monitor the business plan annually or more often, depending on the business. This is to ensure that any required adjustments or modifications are implemented. These adjustments are based on the performance of the business and potential economic changes. The mindset is to maximize future profits and success.

The business must be operated as a business and not a pleasure hobby. Books are used to track income and expenses, assets, and business records. Companies use many ways to promote products and services, find the most affordable ways to operate, and conduct research.

The taxpayer should have expertise in their field of business. People can gain expertise by training, attending seminars, consulting experts, volunteering, and reading from discussion groups. These methods help them become experts in their field.

It’s important to show that you’re running a business, not a hobby, by making sure you have everything in order. This is especially true in areas that could seem more like a hobby than a bona fide business. Activities like photography, music, art, horse breeding, auto racing, and restoration can be looked upon as hobbies. To avoid being categorized as a hobby, it is important to focus on the business aspects of these activities.

If you have any questions regarding hobby losses, feel free to contact me at (408) 684-8505 or email me at dan@oharataxresolution.com