How to Get Around the Limitations of The Hobby Loss Rules

The new tax code makes it more important than ever to ensure your business can’t be called a hobby

Running a side business is trickier than ever when it comes to paying taxes, thanks to the new Tax Cuts and Jobs Act (TCJA) of 2017. For years, taxpayers and the IRS have argued over the definition of a “trade or business” versus a “hobby.”

And now, if the IRS slaps a designation of “hobby” onto your operation, it will eliminate any tax benefits from the activity.

For tax purposes, a hobby is an activity where your prime motivation is having fun instead of making a profit – even if you occasionally do. The IRS requires you to report hobby income on your tax return.

But while a loss from a trade or business is usually deducted in full, the TCJA wiped out any deduction for hobby-related expenses until 2026. Previously, the IRS allowed hobbyists to deduct expenses up to the amount of the activity’s income but did not allow for net losses.

These changes make it critical to establish a money-losing side business as a for-profit operation that has simply not yet crossed into the black. A trade or business, according to the IRS, is an activity you may enjoy, but engage in primarily to make a profit.

Tax court cases abound where the IRS has challenged taxpayers under Internal Revenue Code Section 183 – referred to as the hobby loss rules – in an effort to prevent loss deduction abuses by hobbyists. The rules apply to individuals, S corporations, trusts, estates, and partnerships – but do not impact C corporations.

The IRS warns that it will invoke the hobby loss rules to eliminate loss deductions from operations that it believes do not fit its criteria for a trade or business. It commonly classifies inherently “fun” activities like creating art, photography, writing, jewelry-making, antique collecting, horse breeding, or training dogs as hobbies.

Fortunately, history shows that the IRS loses as many cases as it wins on this issue in court – as long as taxpayers have followed the proper steps to establish a profit motive for their actions.

So, what’s the difference between a business and a hobby?

The easiest way for an activity to avoid getting caught in the hobby loss rules is by turning a profit. The IRS won’t dispute that an activity is for-profit if it earned a profit in three out of the last five years – ending with the last taxable year. For actions involving horses like showing or racing, the rule changes to two of the past seven years.

If the activity is losing money, however, the regulations consider nine factors to determine if your activity is a business or a hobby. If they are all or mostly answered “yes,” the activity is a business. If the answers are all or mostly “no” – it’s a hobby, according to the IRS.

In a nutshell, here’s what taxpayers must consider to avoid being pigeonholed as a hobby:

• Your expertise. Did you study the business practices of your operation? Do you consult with experts to improve your knowledge?
• The manner in which you conduct your activity. Do you keep complete, accurate books? Are records used to improve performance?
• Your time and effort. Is a big chunk of your personal time and effort devoted to the operation?
• An expectation that the assets you use could appreciate in value. And more important, do you have a plan to generate profits if they do?
• The activity’s success. What is your history of profits and losses for this operation? Are profits coming in a reasonable amount of time?
• The number of occasional profits. Even a single year of success can be used as a strong indication that an activity is more than a hobby.
• Your overall track records. How successful have you been conducting other activities? Did you make any of them profitable?
• Your financial status. Do you have other income sources that are being offset by losses from your side activity? Are you rich enough to absorb ongoing losses, which may indicate that your activity is really a hobby?
• The elements of personal pleasure or recreation. If there are substantial personal elements, the IRS is likely to label your activity as a hobby.

Many of these factors are out of your control – but for sure the first three are not. Running your activity in a businesslike manner, talking to experts, creating a business plan – these seemingly obvious steps go a long way toward helping your business escape the hobby zone.

What if the IRS labels my hobby as a business?

Put simply, it’s your lucky day – go ahead and deduct your losses. As an added benefit, an experienced certified public accountant can help you roll losses backward or forward and claim them against profits in another year.

What can I do if the IRS labels my business as a hobby?

To make the case that your hobby is a business, you must be able to prove that you are treating it that way. Besides working to generate profits, make sure you are performing such actions as keeping organized and detailed records, working regularly, invoicing clients, advertising, and writing a business plan that outlines your profitable intentions.

The IRS can be quick to claim that money-losing side businesses are hobbies – and the new tax code tilts the hobby loss rules even less in a taxpayer’s favor. An experienced CPA can help you create a strategy that ensures that your activity falls within the IRS’ definition of a trade or business – and reaps the tax benefits that go along with it.

Provident CPA & Business Advisors serves successful professionals, entrepreneurs, and investors who want to get more out of their business and work less, so they can make a positive impact in their lives and communities. Typically, our clients reduce their taxes by 20 percent or more and create tax-free wealth for life. Contact us for expert advice on the new tax code, and to find out how we can help your business exceed your expectations.