Many taxpayers are engaged in businesses that may be classified as a hobby by the Internal Revenue Service (“IRS”). The tax treatment of a for-profit business versus a hobby is dramatically different. IRC §183 governs the treatment of expenses incurred in the course of producing hobby income.
First let’s discuss how you determine if your business is a hobby. Like most tax determinations, the rules are not completely clear. However, the IRS does state that an activity is presumed to be a for-profit activity if it makes a profit (income exceeds expenses) in at least three of the last five years, including the current year (or two of the last seven years for the breeding, showing, training, or racing of horses).
Even if your business does not generate a profit in three of the last five years, it can still be considered a for-profit activity. However, if your business is audited, you may be required to provide evidence that you operate the business with the intention to make a profit. In some cases having excessive business loses may trigger an audit by the IRS.
The IRS website provides a list of questions that you should ask about your business activity that will help you determine the proper tax treatment:
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 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?
If you determine that your business is an acceptable for-profit activity, then you may deduct ordinary and necessary expenses for conducting the trade or business. In this case, the activity from your business is reported on Schedule C, Form 1065, or Form 1120S (depending on your entity structure). C corporations are not subject to the hobby loss rules.
If you or the IRS determines that your business activity is a hobby, then losses incurred from the activity may not be used to offset other income. The revenue from the hobby must still be claimed as income. However, deductions from the hobby cannot exceed the gross receipt from the hobby. These deductions should be claimed on Schedule A, of Form 1040. The IRS outlines the following guidelines for deducting these expenses on Schedule A:
Deductions that a taxpayer may claim for certain personal expenses, such as home mortgage interest and taxes, may be taken in full.
Deductions that don’t result in an adjustment to the basis of property, such as advertising, insurance premiums and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.
Deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.
It would be to a taxpayer’s advantage that their business be classified as a for-profit business activity rather than a hobby. The ability to use business losses to offset other income in a low performing year could reduce your tax liability significantly.
To the extent you have control over the recognition of expenses from year to year, you can do some tax planning to strengthen your position that your business activity is not a hobby. This may seem counter to most tax planning strategies, but you may want to delay the recognition of some expenses in this case. You could delay an expense by delaying a major purchase to the following year or not electing to take an available §179 deduction. Remember, income in three of the last five years is the rule. In order to make this work you will need to make tax planning a priority. As always, we are here to help you with this planning. Do not hesitate to contact us if you have any questions.