Do you have a business or a hobby?

Taxpayers who engage in side businesses sometimes run afoul of the IRS in distinguishing businesses that do not generate income, or generate consistent losses, from hobbies, instances in which taxpayers use expenses to minimize tax obligations while engaging in activities that more closely approximate recreation than livelihood.

One example often relied upon for illustration is the horse breeder.  Taxpayers have sometimes raised horses for show or riding with no real intention of profiting from the breeding of horses, nevertheless expense out the stable fees, feeding expenses, and travel to exhibitions, thereby generating a loss in the horse endeavor which can be used to offset other income.

Other areas that people have tried variations of this arrangement include : boat rental, luxury box rental, wine making, and gourmet cooking businesses.   The IRS has offered some guidance, focusing not on the activity but on the operation in determining what is a hobby and what is a business, thereby determining which activities can be viewed as potential sources of revenue and  or occasional losses.

IRS Section 183 addresses these issues.   An activity that generates positive revenues in three of five years, including the current year is a business..  Horse breeders need to show profitability in two of seven years.  Conversely, an activity that cannot show positive revenues in three of five years will be presumed to be a hobby,  losses exceeding revenues will not be allowed to offset other income.

Breaking even is acceptable, expenses may not exceed revenues.

The presumption that a money losing endeavor is a hobby may be overcome by evidence and circumstances.  However, Section 183 provides some guidance in arguing in favor of a business:

1. Time spent
2. Reliance on income
3. Losses related to start up costs if reasonable and limited to early years.
4. Do assets appreciate as part of the anticipation of profits in later years? (baseball cards)
5. Has the taxpayer made efforts to improve business efficiency and become profitable?
6. Does taxpayer have knowledge and or skill to successfully operate the activity profitably?
7. Do you have other profitable businesses?

Some areas are more difficult to discern.  Consider for instance a multilevel marketer whose income depends on the wholesaler who provides the products, as well as other sellers who funnel a portion of their income to the recruiters.    If the product line changes, if other sellers lose enthusiasm, the taxpayer may be unable to control the revenues.

One final warning for those who are navigating between the joys and sorrows of hobbies and businesses:  excessive expenses— overdoing the business use of home deduction,  or consistently expenses out equipment and furnishings that may have other uses, may make the IRS less sympathetic to arguments about the efforts to be profitable.