Understand these hobby loss rules to reduce IRS audit risks

VaselineAugust 24, 2024

0 4 minutes read

Understand these hobby loss rules to reduce IRS audit risks

Getting the right tax advice and counsel is vital in the complex tax world we live in. The Kiplinger Tax Letter helps you stay right on the money with the latest news and forecasts, with insights from our highly experienced team (Get a free issue of the Kiplinger Tax Letter or subscribe). You can get the full range of advice just by subscribing to the Tax Letter, but we’ll be featuring snippets of it online regularly, and here’s one of those samples…

The IRS examines tax returns reporting large losses from any activity that sounds like a hobby. Here’s what you need to know about hobby forfeiture rules.

If you start or engage in a business that combines elements of work and play and generates losses, you need to figure out whether your business is a business or a hobby. Business losses are generally deductible on Schedule C of your Form 1040. But there is a double-edged sword when it comes to taxing hobby income. The income you collect from a hobby is taxable. But you can’t deduct your expenses. The 2017 tax law temporarily eliminated until 2025 all miscellaneous itemized deductions previously subject to the 2 percent of adjusted gross income threshold. That includes hobby expenses.

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Claiming large hobby losses on your 1040 form is a first-audit red flag. The IRS looks for taxpayers who, year after year, deduct large losses from hobby activities on Schedule C of their 1040 to help offset other income, such as wages or retirement or investment income. The more consecutive years of losses reported on Schedule C and the larger the amounts, the more likely your tax return will be withdrawn for examination. And if, on top of that, the activity sounds like a hobby, well, that’s red meat for IRS agents. If you are audited, the IRS will make you prove that you have a legitimate business and not a hobby.

To deduct a Schedule C loss, you must show that the activity is a business. The main test to distinguish between a hobby and a business is whether you engage in the activity for profit. For an activity to constitute a business for tax purposes, it must be carried on continuously and regularly in a business manner and you must have a reasonable and bona fide objective of making a profit from it.

IRS regulations provide a safe harbor. If your business generates a profit for three out of five consecutive years (or two out of seven years for horse breeding), the law assumes that you are in business to make a profit, unless the IRS determines otherwise. Hobby-business analysis is more difficult if you can’t meet the safe harbor. This is because the determination of whether an activity is properly classified as a hobby or a business is then based on the facts and circumstances of each taxpayer, the IRS, and the courts generally considering the following nine factors:

The manner in which the taxpayer carries out the activity
Expertise of the taxpayer and/or his advisors
The time and effort put into the action by the taxpayer
The expectation that the assets used in the business can appreciate
Good luck in other activities
History of income and losses (the more years of big, consecutive losses, the harder it is to demonstrate a profit motive, unless the business is still in the start-up stage)
Amount of occasional profits
Elements of personal pleasure or recreation that the taxpayer derives from the activity
If the taxpayer has substantial income from other sources, such as wages, other business income, pension income or investment income

No one factor is determinative, but some are typically given more weight by the IRS and courts. For example, managing and operating your business in a businesslike manner can be extremely helpful in demonstrating a sincere intent to make a profit. Some tax professionals consider this the most important of the nine factors. And more importantly, this factor is under your control. You should open a separate bank account for the business, keep good records, keep receipts for all expenses, advertise, have a business plan and revise it as necessary and change methods of operation or adopt new techniques to transform your business.

Other factors that can help determine the profit motive you need and are also within your control: Make sure you have the knowledge, training or expertise to do the business or rely on the advice of industry experts. You also put a lot of time and effort into the endeavor.

Hobby loss rules are often challenged in Tax Court. When people think of hobby losses, horse and/or dog breeding usually comes to mind. Of course, the Tax Court addressed these actions. But other cases involve activities as varied as ecotourism, rodeo events, acting, writing and research, flying antique fighter jets, playing poker, collecting law enforcement badges, raising donkeys and restoring old cars. The IRS usually wins these cases, in part because it tends to settle cases where it doesn’t think it can prevail. But taxpayers also won in a number of cases.

This first appeared in The Kiplinger Tax Letter. It helps you navigate the complex world of taxes by keeping you up-to-date on new and pending tax law changes, offering tips to reduce your business and personal taxes, and forecasting what the White House and Congress might do with taxes. Get a free issue of the Kiplinger Tax Letter or subscribe.

VaselineAugust 24, 2024

0 4 minutes read

Vaseline

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