Many people have side businesses or activities that they pursue for fun, but may also make money doing. Determining whether these activities qualify as a business or a hobby has serious tax consequences, especially after the passage of the Tax Cuts and Jobs Act (TCJA).
Normal Business Tax Rules
Taxpayers must report business income and expenses on Schedule C. Some businesses, especially new businesses, have higher expenses than income during a particular tax year, leading to a net loss.
You can report this net loss and use it to reduce your other income if your activity qualifies as a business. However, different rules apply if the IRS considers the activity a hobby.
Hobby Tax Rules
Under prior law, taxpayers could deduct some expenses of hobby activities as miscellaneous itemized deductions. If the hobby expenses exceeded the hobby income, the taxpayer was not permitted to take a loss.
Under the TCJA, miscellaneous itemized deductions have been suspended. That means you can’t deduct any expenses related to a hobby activity, but you must still report any hobby income.
Hobby or Business?
So how does the IRS determine whether an activity is a hobby or a business? This question will become even more critical because the new rules penalize hobby activities severely.
The IRS considers all the facts and circumstances of each case, but the primary factor to consider is whether the taxpayer is doing an activity to make a profit.
You can help your case by carrying out your activities in a business-like manner. Keep records, try different strategies to increase profitability, and put in the required effort to make the business profitable. Net losses are fairly common during a startup period, but may look more suspicious after several years of losses.
The IRS provides a safe-harbor that can help you argue that your activities qualify as a business if you meet the following conditions:
- Your activity makes a profit in three of the first five years of operation.
- Your activity makes a profit in two of the first seven years of operation if it involves horse racing, breeding, or showing.
Meeting this safe harbor doesn’t guarantee the IRS won’t claim your activity is a hobby, but it does shift the burden to the IRS. For example, the IRS could claim your business is a hobby if you made very small profits in three years and took massive losses in the other two years.
Get help disputing an IRS hobby loss determination by consulting a tax attorney.
The Gartzman Law Firm offers tax return preparation and tax settlement help. Use our contact form to request a consultation with an Atlanta tax resolution attorney.