A recent IRS notice reminds us that people should know if their pastime is a hobby [an activity engaged in for fun and not profit] or a business [an activity engaged in to produce a profit, at least most of the time]. Income is taxable regardless of whether the activity is a hobby or a business. However, where the distinction becomes meaningful is when the hobby or business is showing a loss. If the activity is a business, the loss may be deductible and may offset other taxable income. If the activity is a hobby, losses are not deductible. Sometimes taxpayers engage in an activity where the profit motive is questionable but deduct the resulting losses in order to reduce their overall tax liability. In such cases, the IRS may challenge the taxpayer's position that the activity is a business and, if successful, deny the deductibility of the losses.
The IRS looks at a number of factors to determine whether an activity is a hobby or a business. No single consideration is the deciding factor, but taxpayers should review all of them when determining whether their activities are a business. Here are the things taxpayers should evaluate to decide whether they have a hobby or a business:
• Whether the taxpayer carries out the activity in a businesslike manner and maintains complete and accurate books and records.
• Whether the time and effort the taxpayer puts into the activity show they intend to make it profitable.
• Whether they depend on income from the activity for their livelihood.
• Whether any losses are due to circumstances beyond the taxpayer's control or are normal for the startup phase of their type of business.
• Whether they change methods of operation to improve profitability.
• Whether the taxpayer and their advisors have the knowledge needed to carry out the activity as a successful business.
• Whether the taxpayer was successful in making a profit in similar activities in the past.
• Whether the activity makes a profit in some years and how much profit it makes.
• Whether the taxpayers can expect to make a future profit from the appreciation of the assets used in the activity.
The IRS listed the following publications for further information:
Publication 17, Your Federal Income Tax
Publication 525, Taxable and Nontaxable Income
Publication 535, Business Expenses
Publication 334, Tax Guide for Small Business, For Individuals Who Use Schedule C