Establish What Activities are Subject to Hobby Loss Rules

Tax Professionals' Resource
June 3, 2014 — 2,721 views  
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Description of the Hobby Loss Rule 

IRC Section 183 puts forth limitations for the expenses that an individual can deduct from his or her various incomes. If an individual continues to incur losses for a business, this may be a red flag to the IRS that the activity is actually a hobby. Activities that are considered to be business “ventures” enjoy numerous deductions, while hobbies do not enjoy these deductions.

To prove that you operate a venture, you must show that a business earns a profit for three out of five consecutive years. If your business continues to suffer losses year after year, you may still be able to convince the IRS that you operate a business. You should be aware that you may be at risk of being audited if your business continues to suffer from losses. 

In the event that a business continues to suffer losses, one will have to show that he or she was serious in attempting to yield a profit. The individual will need to prove that the venture was carried out in a business-like manner. This means that the individual should have tracked receipts and expenses in a software system, sought guidance from experts and spend extensive time in managing the operation. Other factors that a court may consider are the profit that the activity made in the past and whether one depends on income from the activity.

Activities Subject to the Hobby Loss Rule

Section 183 prohibits the classification of losses that are related to activities that are not engaged in for the purpose of making a profit. Individuals must be careful when they attempt to claim a deduction for losses that are related to an activity. The hobby loss rules typically apply to artists involved in creative activities, such as painting, writing, crafting and music. The IRS tends to view certain activities as businesses, such as farming and the practice of law. 

For artists engaged in creative activities, the IRS will closely monitor factors like the historical losses associated with the activity and the individual’s personal pleasure derived from the activity. In some cases, a court may place less emphasis on the historical losses associated with an artist’s activity. In one case, Gullion, T.C. Summ. 2013-65, the court stated “economic success in the arts takes longer to achieve than success in other fields.” The court also maintained that an individual does not need to establish a reasonable expectation of profit in order to engage in an artistic activity for a profit motive. Even a small chance of making a profit will suffice to show that an individual intends to make a profit from a creative activity. 

Carrying on the Hobby in a Business-Like Manner

If one wishes to categorize a hobby as a business, he or she should carry on with the activity in a business-like manner. An accountant may assist an individual in learning the requirements that a court typically assesses in determining whether the activity is a hobby or business. A tax attorney can also be useful in assisting an individual who may be going through an audit under the hobby loss rules.

Tax Professionals' Resource