IF THE EXPENSES of your sideline business exceed its revenues, you may think you can deduct the loss on your return. However, the IRS may claim your purported business is a hobby that never had a chance of being profitable. The IRS likes to make that argument because the tax?rules for hobby losses are not in your favor. Here’s what you need to know.
Why It Matters
When your unincorporated for-profit business activity generates a net tax loss for the year (deductible expenses in excess of taxable revenue), you can deduct the loss on Form?1040. Use Schedule C to report a loss from a sole proprietorship business, and use Schedule F to report one from a farming or ranching venture. The loss is then carried to page 1 of Form 1040 where it offsets income from other sources and reduces your tax?bill. Great!
What happens if your activity is deemed to be a not-for-profit hobby? Not so great. You must report all the revenue on page 1 of Form 1040. However, your allowable expenses are limited to the amount of that revenue. So you can never have a net tax loss from a hobby even if you lose your shirt. Worse yet, you must treat the total amount of hobby expenses (limited to income) as a miscellaneous itemized deduction item on Schedule A. So you get no write-off unless you itemize. Even if you do itemize, your write-off for miscellaneous deduction items is limited to the excess of those items over 2% of adjusted gross income (AGI). If you have a healthy AGI, your deduction for hobby expenses may be little or nothing. Finally, if you’re a victim of the dreaded alternative minimum tax (AMT), hobby expenses are completely disallowed under the AMT rules. When all is said and done, you can easily have a money-losing hobby that actually adds to your taxable?income (because you have to report all the income and may not be able to report much, if any, of the expenses). Your tax bill goes up accordingly. Is this fair and just? Of course not, but too bad if you don’t like it.
Now you understand why the IRS is so enthusiastic about making the hobby loss argument. But don’t give up hope! The good news is yet to come.
Deciding If You’ve Got a Business or a Hobby
Helpfully enough, the tax law automatically assumes you have a for-profit business if the activity produces positive taxable income (revenues in excess of deductions) for at least three out of every five years. Losses from the other years can be deducted because they are considered to be legitimate business losses as opposed to nondeductible hobby losses. For horse racing, breeding, training, or showing activities, you’re assumed to have a for-profit business if you can generate positive taxable income in two out of every seven years. Those who can plan ahead to pass these tests earn the right to deduct their losses from the unprofitable years.
Even if you can’t pass one of these profitability tests, you may still be able to treat your activity as a for-profit business and deduct your losses. Basically, you must demonstrate that you have an honest intent to make a profit. Factors that can prove this intent include: