...a CPA's random thoughts...
Do you have a business or a hobby? What does the IRS think of it?
So you have a business, and you think you can continue claiming tax losses. What does the IRS think of this? Well, it could potentially land you in hot water, especially as a result of TCJA tax code changes applicable to 2018-2025.
The IRS loves to claim that a business that consistently loses money is a hobby rather than a bona fide business. After all, why would a legitimate business continue operating year-over-year while sustaining continuous losses? Hint: it likely will not!
The key is being able to appropriately demonstrate a PROFIT MOTIVE. Then, you may properly claim it is a business and take the losses. Of course, it is not quite that simple.
Generally speaking, if it is an unincorporated for-profit business activity that generates a net tax loss, the loss is normally deductible on Form 1040. The business loss deduction is desirable because it may offset taxable income from other sources, reduces your Federal income tax liability, and also reduces your State income tax liability. But, the same benefits do not exist if your “business” is deemed a hobby by the powers-that-be.
Under current Federal tax law, no deductions are allowed for hobby losses unless you can otherwise claim the deductions under ANY scenario in absence of the activity. You cannot claim hobby losses, but if your hobby generates income, guess what, you better report it as other income!
How do you prove a money-losing business is a bona fide business and not simply a hobby?
- Utilizing a safe harbor, your activity is presumed to be a bona fide business if it produces positive taxable income for three of the last five years*
- *Some activities only require positive net income in two out of every seven years
- Prove intent to earn a profit, such as:
- Conducting the activity in a business-like manner inclusive of good records and seeking out profit-making strategies, including working with professionals to make it a successful business
- Having expertise in the activity, and/or engaging advisers that do
- Putting forth substantial time to demonstrate a profit motive, not simply a hobby
- Expectation of asset appreciation. This is why real estate rental activities are often allowed year-after-year losses, since it is expected the real estate will increase in value
- Success in other ventures such that you can demonstrate business experience and competence
- Financial status. The IRS believes rich people can better sustain consistent losses and therefore may be more likely to deem the activity a hobby
- Lack of elements of personal pleasure…example, draining septic tanks is not pleasurable and would thus more likely be deemed a business relative to being an artist, even if tax losses are identical
Be sure you can demonstrate your activity is a bona fide business before you land yourself in a hot seat with revenue agencies.
Sincerely,
Greg Bennett, CPA