Article: The "Hobby Loss" Rule and the Deductibility of Business Losses

December 2006

The “hobby loss” rule and the deductibility of business losses

Losses sustained in a for-profit business are allowed as deductions against other taxable income. And you already knew that. However, less widely known is that deductions sustained in an activity not engaged in for profit (i.e., a hobby) are governed by Internal Revenue Code Section 183. Expenses that are deemed to be related to a hobby are allowed only to the extent of the income produced by the activity. Furthermore, they are deductible only on Schedule A as a miscellaneous itemized deduction unless they are otherwise deductible without regard to the profit motive (i.e., real estate taxes).

In short, the “hobby loss” rules state that you lose the deductibility of your losses on your tax return when you do not produce a net profit with your business in at least three out of five years. Conversely, generating a profit in at least three of five years (two of seven for certain business activities) ending with the tax year in question constitutes a “safe harbor” that, if met, causes a presumption that the activity is a for-profit endeavor. If this safe harbor is met, the burden of proof for lack of profit motive generally shifts to the IRS.

If the safe harbor is not met, you can still establish a profit motive using subjective factors discussed below. In determining whether you are carrying on your business activity for profit, all the facts and circumstances are taken into account. No one factor alone is used in determining the deductibility of the losses. Among the factors to consider are whether:

You carry on the activity in a businesslike manner.
The time and effort you put into the activity indicate you intend to make it profitable.
You depend on income from the activity for your livelihood.
Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business).
You change your methods of operation in an attempt to improve profitability.
You or your advisors have the knowledge needed to carry on the activity as a successful business.
You were profitable in similar activities in the past.
You can expect to make a future profit from the appreciation of the assets used in the activity.

Here are some other business practices that have helped affirm the business nature of unprofitable activities:

Develop a written business plan that shows how the business can be profitable over time.
Keep good business books and records.
Open a separate checking account.
Consult with experts in the field; document their advice and how it was implemented (or why it was not implemented).
Document your involvement in the activity, not just in hours, but in how your skills will help to make it more profitable.

When the activity involves an element of personal pleasure or recreation (or could be perceived as such by the IRS), it is even more important to document the factors indicating the business is operated with a profit purpose. This is also true if you have substantial sources of income beyond this activity.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.