Business or a Hobby? What does the IRS think you have?
22 July 2013 / Uncategorized / Comments Off on Business or a Hobby? What does the IRS think you have?
Why should we care what the IRS thinks about our activity?
Because under the hobby loss rules (IRC §183) the deductible expenses of a hobby are limited to the amount of income it generates and are further subject to a floor of 2% of adjusted gross income (AGI) as a miscellaneous itemized deduction. For an activity to be considered a business (which allows it to deduct related expenses without limitation) it must be engaged in for profit. If the activity is not engaged in for profit, it is considered a hobby and is subject to the hobby loss rules.
IRS Regulation §1.183-2(b) lists nine factors for determining whether a taxpayer engages in an activity for profit.
- Treated like a business? The first factor is how a taxpayer carries on the activity. The IRS would first be interested in how the taxpayer handles the entity, ensuring that he or she is conducting all activity in a businesslike manner. The taxpayer can establish this by maintaining separate personal and business bank accounts, keeping records and books, and acting like similar profitable, operational entities.
- Is the business owner an expert? The second factor is the expertise of the taxpayer. A business operator should have extensive knowledge of his or her profession or activity, showing that he or she has studied accepted business methods and sought advice from experts.
- Time spent in the activity. The third factor is whether the taxpayer expends substantial time and effort in carrying out the activity. Dedicating personal time to an activity indicates that a taxpayer entered into the activity, or continued the activity, with the actual and honest objective of making a profit.
- An expectation of profits. The fourth factor is an expectation that assets used in an activity, such as land, may appreciate in value. IRS Regulations §1.183-2(b)(4) says such appreciation may be considered in lieu of current profits: “Even if no profit from current operations is derived, an overall profit will result when appreciation in the value of land used in the activity is realized since income from the activity together with the appreciation of land will exceed expenses of operation.”
- Past Experience. The fifth factor recognizes that even if the taxpayer’s activity is currently unprofitable, it may be for-profit if the taxpayer has been able to convert other activities from unprofitable to profitable in the past, especially ones similar to the current activity.
- Past Profitability. The sixth factor looks at the taxpayer’s history of income or losses from the activity. The economy plays a big role in how much a business can generate and keep. If taxpayer’s business is conducted with customers whose business fluctuates with the economy, losses may occasionally be incurred. Losses alone are not conclusive, because IRS §162(a) allows “as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” However, a long series of losses warrants consideration, and sustained earnings indicate a for-profit activity.
- Amounts of Prior Profits. The seventh factor examines the relative amount of the profits and losses. IRS Regulation §1.183-2(b)(7) states, “The amount of profits in relation to the amount of losses incurred, and in relation to the amount of the taxpayer’s investment and the value of the assets used in the activity, may provide useful criteria in determining the taxpayer’s intent.” However, the presumption of profit motive in IRC §183(d) says that if an activity has gross income for three or more of the last five years that exceeds the deductions attributable to the activity, the activity generally is presumed to be for-profit.
- Financial Status of Owner. The eighth factor examines the taxpayer’s financial status, including whether he or she has other sources of income, although their presence does not preclude an activity from being considered for-profit.
- Is the Activity...FUN? The ninth factor is whether the activity provides recreation or involves “personal motives” that may, with other factors, indicate lack of a profit motive. A professional video-game player might have a tough time arguing that the activity is a business as it has large recreational appeal.