Is Your Business a Hobby?

March 13, 2010

This is an important question to ask yourself when you incur losses.  If the IRS determines that your business is indeed a hobby, they can come back and prevent you from deducting your losses on that business.  The most common example of this that I hear is the guy who loves to fish – let’s call him Joe Taxpayer.   Joe figures that he can become a professional fisherman – taking people out on guided fishing trips on Lake Wylie (usually a lot of his friends) and also competing in fishing tournaments throughout the North Carolina and South Carolina.   Now Joe can deduct the cost of his fishing gear, boat, gas, and all of the other ordinary and necessary items that he uses in his fishing “business.”  Or can he?  Is it really a business or is it a hobby?

Is your business subject to the IRS's Hobby Loss Rules?

In order to get to the root answer, the IRS is going to try to determine whether or not Joe had a specific intent to make a profit with respect to his fishing business.    In order for Joe to deduct his losses on the business he must be able to show that it is being run with the intent of realizing a profit.  Keep in mind that Joe doesn’t actually have to make a profit – as long as he intends to make a profit.

Typically, the IRS would presume that Joe had a profit motive if he had profits in any three out of five consecutive tax years ending with the tax year in question. (This is two out of seven years if Joe were involved in breeding, training, showing or racing of horses.)

Of course, it is typical that new businesses lose money for the first few years and it may be hard for Joe to satisfy this guideline.  Because of this, the IRS has developed several factors that they will look at to determine if Joe Taxpayer has a profit motive.  None of these factors alone will determine whether or not the IRS considers Joe’s business a hobby.  The IRS will look at all the factors and assess their opinion on whether or not Joe had a profit motive with his fishing business.

One of the biggest factors that the IRS will use to determine whether or not Joe is operating with an intent to make a profit is the manner of which he operates his business.  Does he keep keep detailed and accurate business records – including current and up-to-date financial information?  Does he keep and maintain business records that are separate from his personal financial records – including a business checking account and credit cards? Joe registered his business with his State?  Has he obtained a trade name and registered it?    Has Joe written a detailed business plan that shows how he is going to obtain profitability and when he is going to get there?

Another factor that the IRS will look at is the expertise that Joe brings to the table.  Does he have the expertise to actually be successful running a fishing business?  Has he consulted with advisors in areas where he may not be proficient.  Sure, Joe may be a great fisherman, but does he have the expertise in the accounting, tax and legal aspects of his business.  What about marketing?  Does Joe have this expertise?  If not, has he consulted with someone who does in an effort to grow his business?

The third factor the IRS will look at is whether or not Joe is spending time and effort on his business.  Does Joe have another job that he works 60 hours a week at?   Does he only spend time on the fishing business at 6am on Saturday morning when he is fishing with his “clients” that happen to be his friends?  Or does Joe spend considerable amounts of time promoting and marketing his business, keeping accurate financial records and reviewing them with a qualified accountant to help him become more profitable?  There is nothing that says Joe can’t work another job, but he must spend a relative amount of time and effort to making sure that his fishing business is successful.

The IRS will also examine whether or not Joe had an expectation that any assets will increase in value.  It is unlikely in Joe’s case that his fishing boat was going to soar in value – nor his fishing gear.  But what if Joe also purchased a small fishing lodge or facility with lake frontage?

The IRS will also review whether or not Joe has had success in other business ventures.  The more success he has had, the more likely the IRS will presume a profit intent.  They will also look at Joe’s fishing businesses history of income and losses.  If he continues to lose money year after year, is he making changes to make his business profitable or is he continuing to run it exactly the same. The willingness to make changes in your business can go a long way toward proving that you have a profit motive.

The IRS will also look at Joe’s overall financial status.  Does Joe have significant income from other sources?  If so, he is less likely to be starting his fishing business with an overall intent to make a profit.  Did Joe quit his primary job to focus on his business full time?  If so, he is much more likely to have a profit motive – especially if he is going to rely on the profits to feed his family.

One of the factors that is going to be the biggest flag for the IRS is the nature of the business.  Is the business one that creates recreational or pleasurable activities for the owner?  The IRS is more likely to consider these as hobbies.  If Joe were to start a fish cleaning business as opposed to a fishing business, it wouldn’t be very likely that the IRS would consider it a hobby.

Remember, the key to all of this is to make sure that you have a profit intent when starting the business.  We all want to do what we love.  Most business books will tell you to find your passion and then start a business around it.  If you do this, you will receive pleasure from your business, but that doesn’t mean it is a hobby.  Make sure you run it like a business!

Donna Bordeaux, CPA with Calculated Moves

Creativity and CPAs don’t generally go together.  Most people think of CPAs as nerdy accountants who can’t talk with people.  Well, it’s time to break that stereotype.  Lively, friendly, and knowledgeable can be a part of your relationship with your CPA as demonstrated by Donna and Chad Bordeaux.  They have over 50 years of combined experience as entrepreneurial CPAs.  They’ve owned businesses and helped business owners exceed their wildest dreams.   They have been able to help businesses earn many times more profit than the average business in the same industry and are passionate about helping industries that help families build great memories.