Hobby or Business?

Peter VanderWoude, CPA, CGMA

June 1, 2016

The US Treasury recently pointed out that the IRS is missing opportunites to identify taxpayers who offset their income with “hobby losses.” Uh-oh! Whether a person’s business is regarded as a hobby, where losses are not deductible, or a business, where losses are deductible, has confused many of us. There is not a clear set of rules, but there are guidelines to make the right call.

Some friends of mine have thought they could not deduct all expenses incurred in carrying on their business if they still have losses in their third and fourth years of operation. They are afraid if they do have a loss the IRS will disallow it. That’s true only if the business is deemed a hobby. The catch, however, is that in an IRS audit the onus may be on them to prove they are carrying on a business. Let’s go over three examples to help you better understand what is a business and what is a hobby.

Gary enjoys golf. He worked as a club pro when he was in his twenties, but when family demands increased Gary needed to find a higher paying job. In his forties, Gary bought a field where he could set up a driving range and pro shop. He developed a business plan and quit his job to invest his time and savings to make a go of his new business. He made improvements to the field to form a driving range and built a small pro shop. He acquired inventory, advertised, hired staff and worked long hours. By his fouth year his business was still losing money.  

Wanda is an attorney who enjoys working with wood. When through her father’s estate his home, woodshop and tools passed to her, she moved in and began making custom furniture gifts for her friends and family. Soon she had all kinds of people beating a path to her door. So she haphazardly set up a business that made a positive income in two of the last five years.

Hank and Hanna have a horse farm with a riding arena where Hanna teaches local youth to ride. Hank has a lucrative job in a nearby city, while Hanna tends to the farm and keeps good records. In seven years, Hank and Hanna have had farm losses in four of those years.

Gary’s, Wanda’s, Hank and Hanna’s income tax returns have been selected for an IRS audit. At issue is the business losses claimed. Andy, the IRS auditor, requested documentation from each person to substantiate their income and expenses. Then he took a closer look at how each business was operated to determine whether there was a profit motive and steps taken to address the losses. How do you think Andy and the IRS would rule in each case? 

First, here are some guidelines to ask yourself:

  • Time and effort indicates profit motive
  • Depend on the income from activity
  • Losses unavoidable or in start-up phase  
  • Operations addressed to improve profitability
  • Owner has specialized knowledge in activity

There is also a profitability test that the IRS uses to determine if your activity is, in fact, a business. If you generated a profit in three of the past five years (two of seven years for horse operations), you probably will fall off the IRS’s radar. If not, you have to show you are in business to make a profit.

So how does Gary fare in the audit? To me it looks like his activity is definitely not a hobby, even though his love of golf led to his business. Hopefully, profitability is just around the corner or he may have to close or sell if his funds run out. How about Hank and Hanna? Likely they are okay as well.  They meet the profitability test. Wanda? Sorry, Wanda!

If you are faced with an IRS audit, it is always wise to have your tax professional represent you. Many taxpayers hurt themselves when they go it alone. Much success in your business!

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