Written by: Tina Powell, CPA

The IRS may question taxpayers regarding whether an activity is a business or a hobby.  If the activity is not engaged in for profit, it is subject to the hobby loss rules.

If an activity is deemed to be a hobby, its income is reported as “other income” on line 21 of Form 1040 and its deductible expenses are limited to the amount of income it generates, subject to a threshold of 2% of adjusted gross income (AGI) as a miscellaneous itemized deduction reported on Schedule A.   

Every situation is unique, and no single factor or pattern is conclusive.  All the facts and circumstances must be considered.  Below are nine factors that aid in determining if an activity is engaged in for profit.

1.       How the taxpayer carries on the activity.  The taxpayer should maintain a separate bank account, keep records and books and act like a business.

2.       The taxpayer’s expertise.  A business operator should have extensive knowledge of his or her profession or activity.  They should show that he or she has studied acceptable business methods and has sought advice from experts.

3.       The taxpayer’s time and effort in carrying out the activity.  How much time and effort is devoted to it on a continual basis?

4.       An expectation that assets used in an activity, such as land, may appreciate in value.  The tax code allows appreciation to be considered in lieu of current profits. 

5.       The taxpayer’s success in other activities.  Even if the taxpayer’s activity is currently unprofitable, it may be for-profit if the taxpayer has been able to convert other activities from unprofitable to profitable in the past, especially ones similar to the current activity.

6.       The taxpayer’s history of income or losses from the activity.  Although the economy may cause fluctuations, sustained earnings indicate a for-profit activity.   The tax code states that if an activity has net income 3 of the last 5 years, the activity is generally presumed to be for-profit.

7.       The relative amounts of the profits and losses.  The amount of profit in relation to the taxpayer’s investment may provide useful criteria in determining the taxpayer’s intent. 

8.       The taxpayer’s financial status.  Although other substantial sources of income to the taxpayer do not preclude an activity from being for-profit, they may indicate the activity is a hobby. 

9.       Whether the activity provides recreation or involves “personal motives.”   Operating an activity like a janitorial cleaning services which includes mopping floors and scrubbing bathrooms lacks recreational appeal, unlike owning horses to ride on your 40 acre farm.

This blog was based on an article written by Robert Gard, CPA from the October 2013 Journal of Accountancy.