Business vs. Hobby: What’s the Difference?
The basic focus of the Section 183 hobby loss provisions is on Section 162 and its “ordinary and necessary” criteria for deducting business expenses and losses. It also mentions the Section 212 investment expense provisions. If your activity is considered not-for-profit rather than a business, the tax rules can find taxable income in some years while disallowing losses in other years, usually for failure to satisfy Section 162.
The Basics of the Hobby Loss Rules
The hobby loss issue has historically emphasized such activities as farming and horse racing, but the rules are not restricted to certain types of businesses. In modern times, for example, occasional use of eBay would not normally rise to the level of a trade or business. It is also quite possible, however, for recurring use of eBay to be considered a trade or business. On the other hand, selling your old golf equipment over eBay wouldn’t convert nondeductible hobby loss into a business loss.
Many factors are considered when distinguishing a business and a not-for-profit activity. There are tests and general rules, but one benefit accruing to taxpayers is that profits in three or more of the five consecutive years ending with the current year translate into a presumption of profit motive.
A key concept here is “activity.” Two or more activities generally cannot be treated as one, yet it may be possible to aggregate them if significantly interrelated. In general, it may be relatively easy to argue for aggregation of activities. (See Publication 5558, p. 21, stressing “organizational and economic interrelationship,” the business purpose for the activities being separate or considered as one and similarity of the activities.)
Early-phase issues can arise, including an activity transitioning from a hobby to a business.
When Section 183 applies, instead of general deductibility, one gets into issues of the order of particular deductions. Category 1 consists of items allowable as deductions without regard to the for-profit question (e.g., home mortgage interest). Because the Tax Cuts and Jobs Act repealed miscellaneous itemized deductions for tax years beginning after 2017 and before 2026, Categories 2 and 3 expenses aren’t deductible as we write in 2022. Hobby losses are actually less deductible under our current environment due to this temporary restriction.
Other potentially important aspects to the business v. hobby question include the self-employment tax, Medicare tax and related deductions.
Distinguishing a Business
The regulations provide the following nine general guidelines for a for-profit business.
1. The manner of carrying on the trade or business, including good books, being able to point to profitable activities similar to yours, adapting to new techniques, scrapping what hasn’t worked and so on, will be considered.
2. The preparation for the activity by study and consultation may indicate profit motive. Disregarding the consultant’s advice may be a negative, but then there is also the new approach argument.
3. The level of activity, such as devoting significant time or withdrawing from another occupation, can be an indication of a business activity. Limited time is a circumstance when competent help can also help prove profit motive.
4. Expected appreciation in values, including land, can be an important factor.
5. A past history of business success can be helpful; e.g., taking a previous loss business into profitability.
6. Staying too long in loss mode is a negative, but then one may also point to special circumstances. In general, the COVID-19 pandemic and other extraordinary problems might indicate special circumstances for staying with an activity.
7. The dimensions of the positives and negatives are important; e.g., small losses and big profits within the context of resources devoted to the activity.
8. Financial status can be a factor; e.g., the rich investing, losing and enjoying the effort.
9. Recreational or personal elements are a negative. If the activity tends to be no fun (author’s paraphrase of “lacks any appeal other than profit”), this is helpful. An interesting sentence in this portion of the regulations says, “It is not, however, necessary that an activity be engaged in with the exclusive intention of deriving a profit or with the intention of maximizing profits.”
An IRS publication discussing these factors advises the IRS auditor to inquire about loans and financing. At the same time, it advises IRS agents to stay focused on the big picture and thus the multitude of factors.
In planning to defend a client on this issue, it may also help to apprise the client of the tax rules and the need for a profit motive. IRS auditors are advised to prepare for the taxpayer’s advisor to argue that losses can be explained as start-up phase losses. They’re also advised to insist on talking to the taxpayer on such issues as start-up losses, even if the advisor prefers to shield the taxpayer. The IRS stresses these “objective factors” while calling the topic “highly subjective.”
Preparing for a Hobby Loss Challenge
A taxpayer victory 10 years ago pointed to the following factors. The context was a mostly-lawyer turned documentary filmmaker claiming significant tax losses: This taxpayer:
- Kept detailed business records,
- Wrote and modified a business plan,
- Solicited outside financing,
- Hired a bookkeeper,
- Obtained liability insurance, and
- Sought feedback from industry pros.
(“New Case Spotlights `Hobby Losses’ of Filmmaker,” Berry, Accountingweb.com, 4/24/12.)
Hobby loss cases deal with all kinds of businesses (or hobbies), some mainstream and some quite unusual. A recent Tax Court decision, another taxpayer victory, found that losses from raising miniature donkeys were business losses. (Huff v. Commissioner, T.C. Memo 2021-140, 12/21/21.)
Each business may well have unique characteristics that require special consideration.
Loss Planning
Net operating loss carryback legislation can be unusual. An important part of planning here is that net operating losses are basically not subject to carryback starting in 2022. There is no net operating loss carryover to mitigate annual accounting with respect to the self-employment tax and Medicare tax.
Section 461(l) now limits the ability to offset nonbusiness income by more than $250,000 of business losses, or $500,000 of business losses if married filing jointly. This relatively recent concept was enacted, then suspended, but is back as of last year. These dollar thresholds are already adjusted annually for inflation.
Tax loss planning and deduction planning may have new limitations that are important considerations. Planning here includes attention to the three-year presumption rule.
Concluding Thoughts
There are many details involved in planning for potential business losses. However, the tax professional needs to keep in mind the underlying importance of prevailing on any business v. hobby question that might be raised by the IRS or state tax authorities. An important element of this planning usually includes educating the client, as well as projecting the client’s numbers.