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Hobby Versus Business Testing
The hobby versus legitimate business is a common question. First, the IRS suggests that incorrect deduction of hobby expenses account for a portion of the overstated adjustments, deductions, exemptions and credits that add up to $30 billion per year in unpaid taxes. So there is a bit of an incentive for the IRS to tackle this issue head on.
Your actions are going to speak much louder than your words. Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit. In order to make this determination, you should consider the following factors:
Does the time and effort put into the activity indicate an intention to make a profit? If you only spend a few hours here and there, this might appear more like a hobby. Keeping a quick logbook or diary listing your hours might be helpful.
Does the taxpayer depend on income from the activity?
If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
Has the taxpayer changed methods of operation to improve profitability?
Has the taxpayer made a profit in similar activities in the past?
Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?
IRS Tax Regulation 1.183-2(b) specifically highlights nine factors-
1. Manner in which the taxpayer carried on the activity
2. Expertise of the taxpayer and his advisors
3. Time and effort expended by the taxpayer in carrying on the activity
4. Expectation that the assets used in the activity may appreciate in value
5. Success of the taxpayer in carrying on other similar or dissimilar activities
6. Taxpayer’s history of income or loss with respect to the activity
7. Amount of occasional profits (if any) that are earned
8. Financial status of the taxpayer
9. Elements of personal pleasure or recreation
No single factor controls and other factors may be considered. Also, if five factors indicate the lack of a profit objective the activity might still be deemed a business and not a hobby.