Hobby Loss vs. Business Checklist

Hobby Loss vs. Business Checklist
Criteria of a business vs. hobby:  There are numerous standards that the courts use in determining whether your activities constitute a business or hobby.  Generally, it is based on the facts and circumstances of each case.[a]  You must show that you entered the activity with the objective of making a profit.[b]  This is true even if there was a small chance of making a huge profit.[b]

Whether or not an activity is presumed to be operated for profit requires an analysis of the facts and circumstances of each case.  Deciding whether a taxpayer operates an activity with an actual and honest profit motive typically involves applying the nine nonexclusive factors contained in Rev. Reg. §1.183-2(b).  Those factors are:

1. The manner in which the taxpayer carries on the activity: If the activity is carried on "in a business like manner and maintains complete and accurate books and records" it is indicative of the activity being for profit.
2. The expertise of the taxpayer or his advisors: "Preparation for the activity by extensive study of its accepted business, economic, and scientific practices, or consultation with those who are experts therein, may indicate that the taxpayer has a profit motive where the taxpayer carries on the activity in accordance with such practices." 
3. The time and effort expended by the taxpayer in carrying on the activity: If a taxpayer devotes a significant amount of time to the activity, it indicates the activity is for profit. The fact that a taxpayer does not devote a significant amount of time to the activity does not adversely affect the for profit determination so long as the taxpayer "employs competent and qualified persons to carry on such activity." 
4. Expectation that assets used in activity may appreciate in value: If the taxpayer expects to profit from the activity, this indicates it is for profit.
5. The success of the taxpayer in carrying on other similar or dissimilar activities: "The fact that the taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable enterprises may indicate that he is engaged in the present activity for profit, even though the activity is presently unprofitable." 
6. The taxpayer's history of income or losses with respect to the activity: "Where losses continue to be sustained beyond the period which customarily is necessary to bring the operation to profitable status, such losses, if not explainable, as due to customary business risks or reverses, may be indicative" that the activity is not for profit. "A series of years in which net income was realized would of course be strong evidence that the activity is engaged in for profit." 
7. The amount of occasional profits, if any, which are earned: "Substantial profit, though only occasional, would generally be indicative that an activity is engaged in for profit, where the investment or losses are comparatively small." Also, "an opportunity to earn a substantial profit in a highly speculative venture is ordinarily sufficient to indicate that the activity is engaged in for profit." 
8. The financial status of the taxpayer: "The fact that the taxpayer does not have substantial income or capital from sources other than the activity may indicate that an activity is engaged in for profit." 
9. Elements of personal pleasure or recreation: "The presence of personal motives in carrying on of an activity may indicate that the activity is not engaged in for profit... It is not, however, necessary that an activity be engaged in with the exclusive intention of deriving a profit." 

The majority of all court decisions indicate that you are required to have an honest profit objective when you undertake this venture.  Thus, if you have a sincere purpose of eventually reaping an overall profit, you will be deemed to have a business motive.[c]   

The Courts have looked at the following factors in deciding if your endeavor is a business or a hobby:   
    1.  Business plan:  Most court decisions have looked favorably on taxpayers who prepare business plans showing projected estimated income and expenses of their endeavor.[d]  The key is to project an overall business profit.  In addition, the projected numbers should have some reasonable basis in reality.  You should; therefore, document how you estimated each of your figures.  If your business contains inventories, you should certainly have enough inventory on-hand to meet your goals.

    2.  Your own statements:  IRS will use your own statements against you.  Thus, don't ever say, "I'm in this only to save taxes or costs, or to get a discount."  In addition, don't have your business plan showing only estimated losses.[e]  

    3.  Manner in which you conduct your activity:  This is probably the single most important factor that IRS uses in judging a business intent from one where there is no expectation of profit.You must conduct your activity in a business-like manner.  Thus, you need to keep a diary and maintain complete and accurate books and records.[f]  Keep separate books and records and bank accounts for your business.[g]

    4.  Run your activity like a similar profitable business:  You should also try to show that your activity is being carried on in a similar manner to other profitable activities.[h] Here is where the principle of duplication is critical.  If you conduct your activity like other successful people in the same business, you have a stronger argument that you have conducted your activity like a business with the expectation of making a profit.  In addition, if you follow the path of successful people, your chances of becoming successful are also enhanced.  Adopt similar marketing efforts to those who are successful.[i]  Thus, you

• Advertise your business
• Have business cards with your business address on it
• Maintain a business telephone listing
• Purchase and use promotional literature
• Use a variety of marketing strategies[j]

    5.  Your prior business experiences can help or hurt:  Your prior business experience in this industry can make a big difference to the IRS.  If you have no prior experience in this endeavor, it is more questionable as to whether you ever had a profit motive.[k]  The courts have held that this lack of prior business experience can be overcome by:

• Extensive study
• Listening to training tapes
• Taking seminars
• Attending training meetings, etc.[k]

You can never get enough training.  Document all training and lectures attended.  Document all help from other successful persons in your business.  The documentation should be in your diary.

    6.  Thoroughly investigate your venture before starting it:  Few good business people start a business without a good prior investigation of the business and any related companies.  It is, therefore, very vital that you conduct a thorough prior investigation of your respective business and company prior to entering the business.[l]

    7.  Get expert advice:  You should consistently consult with experts and other successful people or distributors in your business in order to constantly improve profits.[m]  It goes without saying that you should document their advice and ordinarily follow the advice.

    8.  Devote some time in a regular manner to your activity:  Although you certainly do not need to conduct your activity full-time; the more time and effort, the better.  Cases have shown that as little as on (1) hour per day on the average was substantial enough to support a profit motive.[n]

Businesses are conducted in a regular manner, hobbies are not.  One hour a day for four days a week is better than eight hours once every two weeks.[o]

    9.  Your history of losses/income and steps taken to improve profits: Without question, your expenses can certainly exceed your income in a business.  Absent unforeseen circumstances[p] you should do everything to turn those losses into profits.[q]  However, you should watch out for expenses that are unreasonably excessive when compared to your endeavor's income.  Thus, in one case, an Amway distributor's accounting fees alone exceeded his entire gross income.  There were other items of expenses that also grossly exceeded the income.[k]  The court held that the distributor's activities constituted a hobby and limited all deductions to that income.

Excessive personal unreasonable expenses could be used against you by the IRS as "lack of business profit motive." (e.g. too much Travel & Entertainment expense).  Recent cases note that although you do not have to make a profit, you should have some gross income yearly.  If there is no income provided at all, this is indicative of a hobby.

It is essential that you document:

• All training
• Consultations with experts and other successful people in your business,
• All marketing activities,
• The reasons for all trips noting the business intent and the necessity for this trip in order to "combine personal pleasure with business travel."

Again, the important point is that your activity must be conducted in a business-like manner.

    10.  Amount of income from other sources:  Although it may not seem fair, the greater your income from other sources, the less likely your loss from your activity may be deemed a business loss.[r]  Although this is certainly not a determinative factor, if you have substantial other income from other activities, you need to more closely dot your i's and cross your t's.

    11.  Watch out for certain "inherently suspicious activities":[s]  Certain activities are inherently more suspect by the IRS because of significant personal pleasure involved.  These include:

• Antique collecting
• Stamp collecting
• Traveling
• Writing
• Ministerial duties
• Record recording
• Raising show horses
• Training and showing dogs
• Automobile racing
• Thoroughbred racing

If you find yourself in one of the above-mentioned activities, you must pay careful attention to the "business vs. hobby" factors mentions since your endeavor is inherently suspect.

Business vs. Hobby Loss Checklist

1. Try to have a profit in at least 3 out of 5 consecutive years.  This is not mandatory, but nice to have.
2. Document business intent by sending a letter to your manager or sponsor/company as to why you have entered the business emphasizing your desire to make a long term profit career.
3. Make a business plan showing projected income/expense.
4. If your business contains inventory, always have enough on hand to justify your goals and business plan.
5. Don't make any "improper" statements such as "I'm in this only to save taxes."
6. Keep a good diary and maintain accurate books and records.
7. Utilize advertising, telephone business listings and a variety of marketing strategies.
8. Before entering your business, conduct an investigation of the industry and of any companies that you are thinking of associating with.  Document your steps in this investigation.
9. Keep getting trained and getting tips on operating your business.  This shows that you are constantly trying to make a profit.
10. Document any consulting with successful people or "experts" in your business.
11. Work your business regularly at least one hour a day, four to five times a week.  This should be documented in your diary.
12. Clearly document the reason for making business trips.
13. Be especially careful if you are in one of the "inherently suspicious activities."

Footnotes:

[a]  Rev. Reg. §1.183-2(a)
[b]  Rev. Reg. §1.183-2; Floyd Fisher, TC Memo 1980-183 (1980)
[c]  Maurice Dreicer, 28 TC 642, Aff'd. 702 F.2d 1205 (CA Dist Col. 1983). 
[d]  Rev. Reg. §1.183-2(a); Jonas R. Bryant vs. Comm'r, 928 F.2d 745 (6th Cir. 1991)
[e]  Harry Van Scoyoc, TC Memo 1988-520 (1988)
[f]   Rev. Reg. §1.183-2(b)(i)    
[g]  Frank Suiter, TC Memo 1990-447 (1990); Charles J. Givens, TC Memo 1989-529 (1989); Joseph Ransom, TC Memo 1990-381 (1990) (Amway Distributor); Frank Harris, TC Memo 1992-638 (Mary Kay)
[h]  Rev. Reg. §1.183-2(b)(i)     
[i]  C. Fink Fisher, 50 TC 164 (1968), Acq.
[j]  Sheldon Barr, TC Memo 1989-69 (1989)
[k]   Rev. Reg. §1.183-2(b), Joseph Ransom, TC Memo 1990-381 (1990); Abdolvahab Pirnia TC Memo 1992-137 (1992)
[l]  Wenzel Tirbelmen, TC Memo 1992-137 (1992)
[m]  Rev. Reg §1.183-1(b)(2) 
[n]  Sherman Sampson, TC Memo 1982-276 (1982)
[o]  Percy Winfield, TC Memo 1966-53 (1966)
[p]  Rev. Reg §1.183-2(b)(6)  
[q]  Rev. Reg §§1.183-2(b)(6)&(7)  

[r]  Rev. Reg §1.183-2(b)(8)

[s]  Rev. Reg §1.183-2(b)(9)
References:   

• Botkin, Sanford, Tax Strategies for Business Professionals, The Tax Reduction Institute
• Rev. Reg. §1.183 

Hobby Loss vs. Business Loss

Hobby Loss vs. Business Loss
TURNING HOBBY LOSS INTO BUSINESS LOSS
It happens on more than one occasion that a person turns a hobby into a business and makes money.  After all, if it is something you like doing, you tend to do it better, and spend time learning, improving, and mastering the activity.  These are all some of the basics tenets of success in business.

Your government loves this.  A hobby that starts producing profits means taxable income which translates into more taxes.  Why wouldn't this be well received?

However, the reverse is not always true.  Losses that emanate from a business which could be construed as a hobby-type activity are frequently subject to government challenge in an audit.  This is because these losses can be used to offset other taxable income you may have, resulting in your paying less taxes.  So, there is a form of polarization here.  The taxpayer may be happy with the losses which could save up to 40% in taxes for some.  Obviously, the government may not be as happy with these results.

The key here is to work within the system to be able to use hobby-type losses to save taxes.  The way to do it is to make sure the hobby-type activity qualifies as a business, not a hobby, under the current IRS guidelines.  In terms of IRS tax code, you want to qualify under Code Section 162 (Trade or Business Expenses), or Code Section 212 (Expenses for Production of Income) which refer to a trade or business and/or the production of income.

You don't want to get categorized under Code Section 183 which is an "activities not engaged in for profit," since this makes the net losses non-deductible.

To help your cause in being able to deduct these losses, there are a number of issues, or tests that are considered under current audit guidelines.  The successful qualification within these parameters goes a long way toward the allowance of these losses against other forms of income.  This isn't to say ALL of the guidelines must be met.  It is a matter of the relativity of these guidelines compared to the specific activity in question.  Let's look at the guidelines that are used to establish the activity as a business rather than a hobby.

The main parameters that are currently used as guides to the deductibility of hobby-type business losses are as follows:

1. Amount of profits earned, and occasion of such profits:  Obviously, if the activity produces consistent profits, there is no problem.  There are no losses of concern.  If the profits are only occasional and the losses are more frequent, the tests here are twofold.  First, a relatively large profit, even if only occasional, would tend to support the idea that it is a business more than a hobby.  Second, if the losses are relatively larger than the occasional small profits, and consistently so, then it tends to be viewed more as a hobby.

2. Reason for, or history of losses:  Losses in the early phases of a business are common, and aren't necessarily held against you.  Similarly, losses due to circumstances beyond your control (such as from disease, casualty, weather, market conditions, etc.) are taken into positive reference.  So continued losses without profits in this case would not necessarily be a detriment.

3. The degree of personal pleasure in the activity:  The more this factors in, the more suspect the activity with the IRS.  Model train collecting, horse breeding, art painting, etc., where the business owner or family members participate heavily in the recreational aspects, causes more problems than perhaps other activities.

4. Degree of benefit of losses:  The economic status of the taxpayer enters in here.  The more you have income from other sources besides the hobby-type activity, and the more you benefit from the losses tax-wise, the more it may be challenged.  If you are deriving the bulk of your income from the activity, or if the losses are not saving you much in taxes, it becomes more of a moot issue to challenge.

5. Experience, or expertise of the taxpayer:  Those with significant expertise in the related field, or those who can prove they are making continued efforts to become knowledgeable stand a better chance.  If you use advisers in the activity, if you go to school, trade shows, or buy books, to name a few possibilities, you reinforce that you are trying to make positive efforts to understand the market, and eventually overcome the current losses.

6. Time spent on the activity:  If you spend a significant amount of time in the running of this activity compared to other income-producing activities, it helps show you view this hobby-type activity as more of a business with income potential.  If you spend 3 hours a week on stamp collecting vs 37 hours a week earning money elsewhere, it could be difficult writing-off losses year-by-year from this activity.

7. The "business-like" nature of the activity:  This is perhaps the most frequently-used major test.  One difference between a business and a hobby is in how the activity is run.  If good financial records are maintained, a proper bookkeeping/ recordkeeping system is used, and possibly a separate checking account is kept, then a better case can be made that it is a business, not a hobby.  Similarly, if you can prove you made reasonable attempts to market or advertise this activity to generate revenues, it supports your case.

Is there a Loophole for all of this?
A possible general "loophole" exists where you can show that a reasonable profit occurred in two out five consecutive years of operations.  If this is the case the IRS tends to assume the activity was done for profit, hence the loophole since no challenge may be in order.  Note however, that the degree of profit is important compared to the degree of loss.  Very small profits for two years vs large losses for the other 3 years may not be enough to keep the IRS from trying to challenge.

Since the challenge is done "after-the-fact," the IRS has the benefit of hindsight.  It's too late for you to go back in time to shore up your position.  If you lose this challenge, these losses, both future and past (within the appropriate statute of limitations), can be disallowed resulting in a possible hefty tax bill for you to pay– plus interest and possible penalties.  So contemporaneous recordkeeping and marketing activities are the watchwords here.

However, if you do your homework and the loss-producing activity is handled correctly, this can be a wonderful tax-saving opportunity.  You or members of your family may have the chance to enjoy a fun activity, write-off its expenses, and reduce your taxes all at the same time.  So it is worth the consideration.

Reference: Practice Enhancers, Able & Co.