The IRS Says My Business Is A Hobby. Now What?

Memorial Day weekend was a bust in our home, since my wife and I were sick the whole time. So now that the fun is over, I was having a hard time coming up with something interesting to write that didn’t require hours of research.

Then I got a tax question. It did require research, but it was worth it, and reminded me that I haven’t really addressed the issue of hobby losses on my blog.

Q: The IRS is denying my business related deductions. How do I prove my (failed) business was being run with an intent of profit

Although its policies sometime suck at reflecting this, the government really does want you do have a successful business. Businesses are how wages are paid, are how things are made, how things are purchased, are how people care for themselves and others, and how people pay taxes. Getting into business is a risk, though, and they fail all the time (the exact number varies depending on who you ask). Those losses are real losses, and you can use them to offset other income you may have on your tax return.

What the government doesn’t want, though, is for people to do something for fun, call it a business, and take a deduction. The IRS isn’t in the business of subsidizing your hobby, nor should it be. That’s why the tax code only allows deductions of hobby losses to the extent of your hobby income. For example, if you spend $1,000 a year on various hobby crafting projects, then turn around sell a few of them for $200 on Etsy, you’ll only be able to deduct up to $200 of that $1,000 expense, which will just offset your Etsy income.

Where the debate rages is whether your losses are business losses or a hobby losses. Maybe you really thought you could make a business selling Intestine Necklaces. If you can prove it was intended as a business, you can deduct all of your business losses.

Safe Harbor

If you make a profit in 3 out of 5 consecutive years (or 2 out of 7 for horse activities), the IRS will generally agree that your activity is a business and leave you alone.

This post is getting to serious, so here's a random picture of a cat to lighten things up

This post is getting to serious, so here’s a random picture of a cat to lighten things up

Out In The Stormy Seas

In the question above, the person really tried to make a business but gave up after 3 years. The IRS came in to claim the activity was as hobby rather than a business, which would stick the losses under the unfavorable hobby loss rules. Since there were no years of profit, how do they prove to the IRS the activity really was a business?

For better or worse, there’s no set checklist to prove you’re a business. It’s all facts and circumstances, which includes the grumpiness of your IRS agent on that particular day. Fortunately, the IRS does provide a list of items to help them decide if your activity is a business (from Treas. Reg. § 1.183-2(b):

  1. The manner in which the taxpayer carried on the activity,
  2. The expertise of the taxpayer or his or her advisers,
  3. The time and effort expended by the taxpayer in carrying on the activity,
  4. The expectation that the assets used in the activity may appreciate in value,
  5. The success of the taxpayer in carrying on other similar or dissimilar activities,
  6. The taxpayer’s history of income or loss with respect to the activity,
  7. The amount of occasional profits, if any, which are earned,
  8. The financial status of the taxpayer, and
  9. Elements of personal pleasure or recreation.

In less legalese, you have to ask yourself questions like the following:

  1. Do I have any flippin’ idea how to run a business?
  2. Do I have any flippin’ idea how to do the work I’m trying to sell?
  3. Is there any evidence that I could make money on this?
  4. Is there any evidence that I’m actively trying to make money on this?
  5. Is this something that many people do just for fun?

Let’s look at a couple of quick examples so we’re all on the same page.

Example 1: Eva works for a large company as an accountant. She decides to head off on her own. Although she’s never run a business before, she does know accounting, and her accounting expertise has given her a general idea how businesses are run. She’s out there every day trying to make new clients. She still manages to lose money and calls it quits after 3 years. The IRS decides it’s a business because (a) it’s run like a business, (b) she knows what she’s selling, and (c) no sane person would consider accounting to have any elements of personal pleasure or recreation

Example 2: George has a pet monkey. He started making hats for the monkey, which turned out really well. He quit his job as a clothing designer and started selling the monkey hats online. He has a long list of successful clothing lines, and knows how to run a business. However, nobody wants monkey hats. The business fails. The IRS gives the company a second look because making monkey hats sounds like a hobby, but decides it’s a business based on George’s experience and way he ran it.

Example 3: Casey is an HR Manager who spots a serious deficiency in all HR software. She buys a computer and programming lessons. She tries to make a good piece of software, but ultimately fails. She has no experience running her own business, programming, nor has any evidence of any sort of legitimate business plan. The IRS comes in and decides it’s a hobby.

Now, any of these examples could have potentially gone the other way. If Eva had no experience in accounting and tried to set up shop, the IRS would likely decide that Eva was “playing accountant,” limit her deductions to a hobby, and notify the local authorities about Eva’s insanity. George likewise would have had a hobby if he didn’t have any experience in making and selling clothing. And Casey could have had a business if she’d had programming and/or business experience.

Document, Document, Document

If your taking deductions for a failed business, chances of an IRS audit skyrocket. They might want your business to succeed, but once you’ve given up on it, they want you to take as few deductions as possible.

So how do you prove to the IRS that you really had a business rather than a hobby?

Documentation.

My advice to the person asking me the question above was to give to the IRS at least the following:

1. A Business Plan
2. List of people working on the project, including their qualifications and past successes
3. Proof of clients. If you didn’t have any, potential clients and their feedback will have to suffice.
4. Financial Statements of some sort. Something official prepared by a CPA is ideal, but anything showing that you are tracking your income and expenses in a methodical manner is good.
4a. While you probably shouldn’t dump your receipts on the IRS on the first go around, make sure you have them in case they question any of your expenses.
4b. Ideally, your business is run through a separate checking account from your personal account.
5. Any sort of documentation showing how your position is similar to the work you previously were employed to do. Your goal on this one is just to give additional evidence that you knew what you were doing and you weren’t just having fun.

If you can prove this all out to the IRS, you should be good. It’s not a guarantee, especially if you’re doing something that most people do for fun. And, like any interaction with the IRS, you should probably consult a CPA or enrolled agent.

Good luck, both with this, and any future business endeavors.