Pay attention to the tax rules if you turn a hobby into a business

5/7/2024

Commentary by:

CPA

In accounting, the term “hobby loss rules” is used when turning a hobby into a business. By adding your business to your tax returns, you have indicated that your business venture can be tax deducted. However, if we notice the business is not making profit, showing losses year after year, and a lack of record keeping, the IRS will intervene. The IRS put rules in place to prevent abuse from deducting ordinary and necessary business expenses.

There are two ways to avoid the hobby loss rules.

Make sure your business shows a profit at least three out of five consecutive years. There are some business types where profit must be shown every two out of seven years, but most businesses are three to five. If you make a profit on a rolling basis, the IRS is unlikely to review your tax return.

If you show losses three years in a row or three out of every five years, the IRS won’t necessarily intervene. I tell my clients that it could raise a red flag if losses continue to trend downward. However, if you show profit and pay taxes on the profit, they won’t question it.

Running your business in a professional and businesslike manner, rather than a hobby, is crucial for avoiding tax problems. If you are only engaging in the business for profit, then the IRS will get involved. The IRS will also investigate factors such as how you run the activity.

If your business operates with a website, Facebook page, or some proof of brand identity, then your business will not be flagged by the IRS. If you have not advocated for your business in one of those ways or similar, and your intent is only to make profit, the IRS will address the issue.

One of the most important aspects of turning a hobby into a business is recording keeping. Make sure to keep a detailed document or excel sheet that showcases expenses and time. Track how much time (days, hours, months) you have put into the business. The more records you have on file, the easier it will be if the IRS investigates your tax return. At the end of the day, their job is to prevent abuse of deductions.

Starting a business that you are passionate about usually means you are an expert in that field. Coming into possession of money and starting a business on a whim does not mean you’re an expert. This can cause the IRS to investigate and cause issues for your business and your tax return.

To transition a hobby into a business, create an LLC or a separate entity to house all the activity. For instance, if you sell sports cards on eBay, you may reach a certain level of revenue prompting eBay to send you a 109 tax form. Then, you could turn that hobby into a business, by creating an LLC. Operate under the new entity within your state, to distinguish your business from personal affairs. This helps to demonstrate your commitment to the business and establish legitimacy.

If you have questions on how to turn your hobby into a business, consult the tax professionals at 415 Group.

Many people dream of turning a hobby into a regular business. Perhaps you enjoy boating and would like to open a charter fishing business. Or maybe you’d like to turn your sewing or photography skills into an income-producing business.

You probably won’t have any tax headaches if your new business is profitable over a certain period of time. But what if the new enterprise consistently generates losses (your deductions exceed income) and you claim them on your tax return? You can generally deduct losses for expenses incurred in a bona fide business. However, the IRS may step in and say the venture is a hobby — an activity not engaged in for profit — rather than a business. Then you’ll be unable to deduct losses.

By contrast, if the new enterprise isn’t affected by the hobby loss rules, all otherwise allowable expenses are deductible, generally on Schedule C, even if they exceed income from the enterprise.

Important: Before 2018, deductible hobby expenses could be claimed as miscellaneous itemized deductions subject to a 2%-of-AGI “floor.” However, because miscellaneous deductions aren’t allowed from 2018 through 2025, deductible hobby expenses are effectively wiped out from 2018 through 2025.

How to NOT be deemed a hobby

There are two ways to avoid the hobby loss rules:

Show a profit in at least three out of five consecutive years (two out of seven years for breeding, training, showing or racing horses).
Run the venture in such a way as to show that you intend to turn it into a profit maker rather than a mere hobby. The IRS regs themselves say that the hobby loss rules won’t apply if the facts and circumstances show that you have a profit-making objective.

How can you prove you have a profit-making objective? You should operate the venture in a businesslike manner. The IRS and the courts will look at the following factors:

How you run the activity,
Your expertise in the area (and your advisors’ expertise),
The time and effort you expend in the enterprise,
Whether there’s an expectation that the assets used in the activity will rise in value,
Your success in carrying on other activities,
Your history of income or loss in the activity,
The amount of any occasional profits earned,
Your financial status, and
Whether the activity involves elements of personal pleasure or recreation.

Case illustrates the issues

In one court case, partners operated a farm that bought, sold, bred and raced Standardbred horses. It didn’t qualify as an activity engaged in for profit, according to a U.S. Appeals Court. The court noted that the partnership had a substantial loss history and paid for personal expenses. Also, the taxpayers kept inaccurate records, had no business plan, earned significant income from other sources and derived personal pleasure from the activity. (Skolnick, CA 3, 3/8/23)

Contact us for more details on whether a venture of yours may be affected by the hobby loss rules, and what you should do to avoid tax problems.

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Pay attention to the tax rules if you turn a hobby into a business

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