Turning a hobby into a business can be an exciting proposition. But don’t get tripped up by the IRS’s “hobby loss” tax rules.
What’s the Difference?
Basically, a trade or business is an activity you engage in to make a profit (whether or not a profit actually results). A hobby, on the other hand, doesn’t have a profit motive. If the IRS views your activity as a hobby rather than a business, your tax deductions for business expenses generally will be limited to the extent of income from the activity.
What Does It Take?
The IRS will presume your activity is a trade or business if you’ve shown a profit in three of the past five years (two out of seven years if the activity involves breeding, showing, training, or racing horses). If your profit “picture” isn’t conclusive, there are nine subjective factors the IRS then uses to determine whether a profit motive exists.
A Tale of Two Court Rulings
A law firm partner who produced a documentary film in her spare time was found by the U.S. Tax Court to have a profit motive because she conducted the activity in a businesslike manner. Specific points in her favor included that she created a production company with separate bank accounts, obtained proper liability insurance, and spent numerous hours a week working on the project.
An individual who was a photographer, however, did not pass the profit motive test, said the court, because the activity was not conducted in a businesslike manner. Key factors included the photographer’s failure to keep a separate bank account and to make significant efforts to improve profitability.