Is Your Sideline Activity a Business (Good) or a Hobby (Not Good)?

Do you have a sideline activity that you think of as a business?

From this sideline activity, are you claiming tax losses on your Form 1040?

Will the IRS consider your sideline a business and allow your loss deductions?

The IRS likes to claim that money-losing sideline activities are hobbies rather than businesses. The federal income tax rules for hobbies have been anti-taxpayer for years, and now an unfavorable change enacted in the Tax Cuts and Jobs Act (TCJA) made things even worse for 2018-2025.

If you have such an activity, we should have your attention.

Here’s the deal: if you can show a profit motive for your now-money-losing sideline activity, you can classify that activity as a business for tax purposes and deduct the losses.

In this article, we give you what you need to know about the federal income tax rules for hobbies and how to tilt the playing field in your favor.

But first, let’s cover the necessary background information. Onward.

Tax Rules for Hobbies

If you operate an unincorporated for-profit business activity that generates a net tax loss for the year (deductible expenses in excess of revenue), you can usually deduct the loss currently on your Form 1040.

The business loss deduction

• offsets taxable income from other sources;
• reduces your federal income tax bill accordingly; and
• reduces your state income tax bill too, if you have one.

On the other hand, if you must treat a money-losing activity as a not-for-profit hobby, the tax results are not good.

Hobby Loss Rules before the TCJA

Before the TCJA, if your activity was deemed a not-for-profit hobby, you had to report all the revenue on Form 1040 as “other income.”

You could deduct expenses that you could write off in any event, such as itemized deductions for home mortgage interest and property taxes allocable to space used for your hobby. But deductions for other expenses were limited to the amount of revenue, and those expenses were treated as itemized deduction items because they were not from a business activity.

So, you could not deduct a hobby loss even if you lost your shirt.

Worse yet, you had to treat allowable hobby expenses (other than expenses that you could write off in any event) as miscellaneous itemized deductions that were subject to a 2 percent-of-adjusted-gross-income (AGI) deduction threshold.

Thus, you got no write-off unless you itemized. Even if you did itemize, your write-off for miscellaneous deductions was limited to the excess of those items over 2 percent of AGI. If you had a healthy AGI, your deduction for hobby expenses might have been little or nothing.

Finally, if you were a victim of the dreaded alternative minimum tax (AMT), miscellaneous itemized deductions for hobby expenses and property taxes allocable to your hobby were completely disallowed for AMT purposes.

But the TCJA made things worse.

Current Hobby Loss Rules under the TCJA

For 2018–2025, the TCJA eliminates regular federal income tax write-offs for miscellaneous itemized deduction items that were previously subject to the 2 percent-of-AGI deduction threshold.

This change wipes out all deductions from hobby activities, other than expenses that you can write off in any event (such as itemized deductions for mortgage interest and property taxes allocable to space used for your hobby).

So, under current law, hobby-related deductions are completely disallowed for regular federal income tax purposes as well as for AMT purposes.

As before, you must still report 100 percent of hobby-related income as “other income” on your Form 1040. So, the tax rules for hobbies have gone from bad to worse. Ugh!

Expect IRS auditors to focus even more attention on folks with money-losing sideline activities. That means it’s now more important than ever to establish that your money-losing activity is actually a for-profit business that has simply not yet become profitable. Keep reading.

Determining whether the Activity Is a Business or a Hobby

Now that you understand why hobby status is bad and for-profit business status is good, the next step is determining whether your money-losing activity is a hobby or a business. Here’s how.

Take Advantage of Safe-Harbor Rules if Applicable

Helpfully enough, our beloved Internal Revenue Code has two statutory safe-harbor rules for determining whether you have a for-profit business.

1. Your activity is presumed to be a for-profit business if it produces positive taxable income (revenues in excess of deductions) for at least three out of every five years. You can deduct losses from the other years because they are considered business losses rather than hobby losses.
2. A horse racing, breeding, training, or showing activity is presumed to be a for-profit business if it produces positive taxable income in two out of every seven years.

Key Point. If you can plan ahead to qualify for these safe-harbor rules, you earn the right to deduct your losses in unprofitable years.

Prove Intent to Make Profit

If you cannot qualify for one of the two safe-harbor rules above, you may still be able to treat the activity as a forprofit business and rightfully deduct the losses. Basically, you must demonstrate an honest intent to make a profit.

Factors that can prove (or disprove) such intent include:

• Conducting the activity in a business-like manner by keeping good records and searching for profitmaking strategies.
• Having expertise in the activity or hiring advisers who do.
• Spending enough time to justify the notion that the activity is a business and not just a hobby.
• Expectation of asset appreciation: this is why the IRS will almost never claim that owning rental real estate is a hobby, even when tax losses are incurred year after year.
• Success in other ventures, which indicates that you have business acumen.
• The history and magnitude of income and losses from the activity: occasional large profits hold more weight than more frequent small profits, and losses caused by unusual events or just plain bad luck are more justifiable than ongoing losses that only a hobbyist would be willing to accept.
• Your financial status: “rich” folks can afford to absorb ongoing losses (which may indicate a hobby) while ordinary folks are usually trying to make a buck (which indicates a business).
• Elements of personal pleasure: breeding race horses is lots more fun than draining septic tanks, so the IRS is far more likely to claim the former is a hobby if losses start showing up on your tax returns.

Examples of Taxpayer Wins on Business-versus-Hobby Issue

Just to prove that we are not blowing smoke by stating that taxpayers can sometimes prove that money-losing activities are for-profit businesses rather than hobbies, consider the following semi-recent Tax Court decisions.

“Weekend Rancher” Had a For-Profit Business

In the facts underlying a 2017 Tax Court decision, the married, jointly filing taxpayers were an economics consulting firm owner and his sociologist wife. They deducted millions of dollars in losses for 2007-2010 (the tax years in question) from hay production, cattle raising, and cutting-horse breeding and training operations that were conducted on the husband’s 8,700-acre ranch. The taxpayers treated the ranching operations as a single aggregated activity for purposes of determining whether the ranching activity was conducted for profit.

The operations had a high degree of organizational and economic interrelationships and were overseen by a single ranch manager. The losses from the aggregated ranching activity were reported by the taxpayers on a single Schedule F.

After an audit, the IRS denied the losses on the grounds that the ranching activity was a hobby rather than a forprofit business.

The Tax Court disagreed, even though the husband was only a “weekend rancher” and did not have a written business plan for the ranching activity. Thankfully, other evidence showed that the husband conducted the ranching activity in a businesslike manner because he:

• kept books and records for the activity and had a separate bank account for the activity,
• made changes to improve profitability, and
• vertically integrated the ranching operations.

The hay-production operation provided feed for the cattle-raising operation, which in turn provided calves to use in the cutting-horse breeding-and-training operation.

Other favorable factors were that:

• the husband had been involved in agricultural activities from a young age,
• professionals were hired to carry out the various operations, and
• the ranching assets were expected to appreciate in value.

The ranch had 25 full-time employees who received annual salaries ranging from $25,000 to $115,000, and the ranch also employed part-time hands as needed. Over the years, the husband realigned the workforce to reflect current needs and fired employees for nonperformance or inappropriate behavior.

The ranchland had an appraised value in excess of $30 million.

The large losses that were incurred in 2007-2010 were to be expected in the early years of the ranching operations.

Since the court found the ranching activity to be a for-profit business, the taxpayers’ claimed losses were allowed in full. Taxpayer wins!

Auto Restoration Activity Was a For-Profit Business

In the facts underlying a 2016 Tax Court decision, the taxpayer was a patent attorney who restored classic Plymouth automobiles on the side. He managed all aspects of the restoration activity, including arranging for advertising, inventory maintenance, and sales.

On his 2009 federal income tax return, the taxpayer deducted various expenses related to the restoration business. After an audit, the IRS disallowed the deductions on the grounds that the activity lacked a profit motive and was therefore subject to the dreaded hobby loss rules.

Had the IRS prevailed, the tax and penalty hit to this taxpayer would have been

• $27,208 in taxes,
• a $6,802 Section 6651(a) addition to tax, and
• a $5,442 Section 6662 accuracy-related penalty.

The court had this to say on why it ruled for this taxpayer:

• Although his manner of carrying on this activity was unsophisticated, it was businesslike.
• He had experience operating a business and expertise relating to Plymouths; advertised online, in print, at live events; traveled outside California to acquire cars at bargain prices; contracted with third parties to manufacture parts for him to resell and use in restorations; and abandoned unprofitable aspects of his automobile activity.
• Furthermore, he devoted considerable time to, and handled all material aspects of, his automobile activity.
• Lastly, the taxpayer’s patent business was undergoing a downturn during the year in issue, and the taxpayer, a prudent businessman, would not have squandered his hard-earned money on an expensive hobby.
• In short, the taxpayer’s automobile activity was a business, and his primary objective was to make a profit.

Taxpayer wins!

Seventh Circuit Rebuked Tax Court for Poorly Reasoned Anti-Taxpayer Hobby Loss Decision

In another 2016 decision, the Seventh Circuit Court of Appeals harshly criticized a 2014 Tax Court decision that disallowed losses from the early years of a taxpayer’s horse training and breeding operation under the hobby loss rules. The taxpayer had been a successful nightclub and restaurant owner before he became a licensed horse trainer.

The Tax Court concluded that during the first two years of the horse operation, the activity was not a business but that it became one in later years. The Tax Court said the taxpayer’s substantial expenditures for a land purchase and improvements in those years were irrelevant and ignored the fact that the taxpayer conducted the operation in a businesslike manner with the expectation of future profits.

Thus, the Tax Court disallowed the losses from the two years in question under the hobby loss rules.

“Whoa!” said the Seventh Circuit in concluding that the Tax Court’s decision was untenable, because it effectively meant that every business is a hobby during the money-losing start-up phase and only becomes a business when it achieves profitability. Under the Tax Court’s faulty reasoning, Facebook, Microsoft, Apple, and Amazon would have been considered hobbies during their early money-losing years.

The Tax Court considered the taxpayer’s large expenditures to buy land and make improvements irrelevant to his profit motive until after he began using the new facilities. The Seventh Circuit noted that this finding was an offense to common sense.

The Seventh Circuit further noted that the taxpayer derived pleasure from the horse operation, but that fact did not by itself mean it was a hobby rather than a business.

Finally, the Seventh Circuit noted that the Tax Court’s decision abounded with inconsistencies and misunderstandings of the taxpayer’s obvious for-profit motives. The taxpayer’s losses for the two tax years in question were allowed as fully deductible business losses. On appeal, taxpayer wins!

Takeaways

If you have a money-losing sideline activity, business status is good for your tax health.

Hobby status is bad for your tax health, especially under the TCJA.

You may be able to take advantage of a statutory safe-harbor provision for your money-losing sideline activity.

If a statutory safe-harbor provision is not in the cards, you may be able to take advantage of the fact that the Tax Court has concluded that a number of pleasurable activities can be classified as for-profit businesses rather than hobbies.

So, there’s often reason for hope. Use the factors listed in this article to evaluate your situation.

The business-versus-hobby issue has been a hot button for the IRS, and the unfavorable TCJA change added fuel to the fire. So before you ever get audited on the issue, it’s important to document that you are on the right side of as many factors as possible.

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