For taxpayers there is an important distinction between what the IRS considers a hobby and what is considered a business. Internal Revenue Code Section 162 allows the deduction of ordinary and necessary business expenses if they result from a trade or business. On the other end of the spectrum, Code Section 183 limits the deductions for taxpayers related to activities not engaged in for profit. The expenses may only be deducted to the extent of gross income from the Section 183 activity.
Determination of Business or Hobby
Generally a business is entered into for profit. In order to be characterized as a business, there must be intent to make a profit. A hobby may be entered into for recreation, not to make a profit. The IRS has provided nine factors to help determine if a business is operated for a profit:
- Whether the activity is carried on in a businesslike manner.
- Whether the time and effort put into the activity indicate that the intent is to make a profit.
- Whether the taxpayer depends on the income from the activity to support his/her livelihood.
- Whether losses from the activity are due to circumstances beyond control (or are normal in the startup phase for that type of business).
- Whether methods of operation are changed in an attempt to improve profitability.
- Whether the taxpayer or the taxpayer’s advisors have the knowledge necessary to carry on the activity as a successful business.
- Whether the taxpayer was able to make 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 activity is expected to make a future profit from the appreciation of the assets used in the activity.
In addition to the nine factors listed above, the IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five years, including the current year. (An exception would be for activities that consist primarily of breeding, showing, training or racing horses, the IRS looks for a profit in at least two of the last seven years.)
The taxpayer has the burden of proof related to proving the required profit motive. A court will weigh all the facts and circumstances, with greater weight given to objective facts than to the taxpayer’s mere statement of intent.
Limits on Deductions for a Hobby
Deductions from hobby activities are limited to the gross income from that activity. If an overall loss occurs for a hobby activity during a tax year, this loss cannot be used to offset other types of income.
The deductions for hobby activities must be claimed as itemized deductions on Schedule A of Form 1040. Therefore, a taxpayer must itemize deductions to deduct any expenses related to the hobby activities. They must be taken in the following order and only to the extent stated:
1. Deductions that a taxpayer may take for personal as well as business activities, such as home mortgage interest and taxes. These may be taken in full. They should be listed on the correct lines on Schedule A.
2. Deductions that do not result in an adjustment to basis, such as advertising, insurance and wages. These may be deducted to the extent gross income for the activity is more than the deductions from the first category.
3. Deductions that reduce the basis of property, such a depreciation and amortization. These are taken last and only to the extent that gross income for the activity is more than the deductions taken in the first two categories.
Deductions in the second and third category must be claimed as miscellaneous deductions on Schedule A. That makes them subject to the 2% of adjusted gross income (“AGI”) limit. What this means is that in addition to the limits already discussed, the deductions must also be greater than 2% of a taxpayer’s AGI before any deduction can be claimed.
The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.
Hobbies do not receive favorable tax treatment by the IRS, so it is important to determine if an activity will be deemed a business or a hobby for income tax purposes. To be a business, the activity must be carried on with the intent of making a profit. An activity that is not a business will have limits on the amount of deductions it can take, and any losses from the activity cannot be used to offset other types of income.