A BUSINESS BY ANY OTHER NAME MAY BE A “HOBBY”
Mike Harris is the proud owner of a deep-sea fishing boat. Although fishing for tuna and swordfish isn’t his primary line of work, he takes the “Mariner’s Mermaid” out most weekends and often sells his catch. Although Mike considers fishing a sideline occupation, the Internal Revenue Service (IRS) may or may not agree with him. What Mike considers a bona fide business, the IRS may judge a hobby.
What difference does it make? To the IRS—plenty. This is because tax rules for writing off expenses and losses differ, depending on whether the activity is a business or a hobby. If Mike is engaged in a business (for profit), and the IRS agrees, Mike can use any business loss (business expenses in excess of business income) to offset his income from other sources, such as wages, interest, dividends, and capital gains.
On the other hand, if Mike’s fishing excursions are deemed a hobby (not for profit), he can’t report a loss from the activity, and he can only deduct related expenses if he itemizes deductions. Moreover, these expenses are characterized as miscellaneous deductions subject to the 2% of adjusted gross income (AGI) limitation.
Hobby or Business?—Six Ways to Tell
How does Mike know whether he’s engaged in a hobby or a business? In many cases, there may be a fine line between the two. To help make the distinction, the IRS provides a number of guidelines:
Profitability. The activity is presumed to be “for profit” if it is profitable in at least three out of five consecutive years. (A “two out of seven years” rule applies to the breeding, training, showing, or racing of horses.)
Pattern of Profit and Loss. Losses in the early stages of a business may be justifiable, but, if they continue for long, the IRS requires a firm basis for declaring the activity is a business, not a hobby. The IRS may also look at the profit or loss generated by the activity relative to the amount invested in it.
Time and Effort Expended. Another measuring stick is the amount of time devoted to the activity. If Mike has created multiple ventures staffed by paid workers, he may not have to spend significant time deep-sea fishing to prove it’s a business. However, if the IRS considers the activity recreational for his particular circumstances (which would be likely if he’s a full-time computer consultant, rather than a commercial fisherman), he may have a more difficult time proving it’s a business.
Percentage of Total Income. The IRS tends to view activities that generate a small percentage of total income as hobbies. On the other hand, if there is little or no income from other sources, the IRS may be more likely to consider the activity a business.
Record Keeping. Bona fide businesses are expected to keep complete and accurate accounting records. A casual or incomplete set of books may cause the IRS to conclude the activity is a hobby, rather than a business.
Existence of a Business Plan. Drafting a business plan before starting a venture, or before converting an existing hobby, helps substantiate the activity as an actual business. If Mike developed a business plan before he began his weekend deep-sea runs, he has a better chance of convincing the IRS he intended to conduct the activity as a business.
So, hobby or business? These IRS guidelines can help Mike classify his fishing trips. Since tax regulations are more favorable for businesses than for hobbies, the burden of proof is on Mike to convince the tax authorities that when he leaves port, he’s on a business trip.