This might come as a shock to those who think the IRS has already been aggressive in enforcing hobby loss limitations, but the Treasury Inspector General for Tax Administration (TIGTA) disagrees. The TIGTA believes the IRS has been lax in going after hobby loss tax cases, and this is likely a harbinger for increased crackdowns on hobby loss deductions. The TIGTA’s most recent report also provides valuable information about what the service considers potential audit triggers and how to avoid them.
Hobby Versus Business
Nine factors are looked at in distinguishing between a hobby and a business activity. They are:
- How you execute the activity
- Your level of expertise
- How much time and effort you put into the activity
- The amount of occasional profits, if any
- Whether or not you think the assets used in the activity will increase in value
- Your financial status
- Prior success in similar ventures or activities
- Income or loss history associated with an activity
- Elements of recreation involved in the activity
Bear in mind that not all these factors are seen as equal. Let’s look at ways to protect yourself if you want to stay out of trouble.
Play Wait and See
The IRS makes the assumption that if you made money in any three of the last five years, then you are really in business and trying to turn a profit. Horses are the exception, where if you make money in any two out of the last seven years you are generally safe.
You can front-run the IRS and buy yourself more time in determining whether your activity qualifies as a business or a hobby by filing Form 5213. Form 5213 is an election that extends the make versus lose money presumption, but that extra time comes with the catch of extending the statute of limitations.
Put It Off Until Tomorrow
Suppose you lost money in your first two years. Now in year three things are not looking too good either. You can avoid the presumption that your activity is a hobby by deferring losses. If you can consider yourself as not "materially participating" in the activity, then your losses will be considered passive and you will not be able to deduct them on your return in that year. Instead they are suspended and carried forward so you can use them against a profitable year in the future.
Write a Business Plan
You can go a long way to help substantiate that your activity is a real business and not just a hobby by writing a business plan. Changing that business plan to adapt to circumstances helps even more. If you have losses year after year and are not documenting a concrete strategy to avoid it and turn a profit, that doesn’t bode well for you. The IRS knows people lose money on ventures, but they expect if you are running a business that you will try to avoid this by changing your strategy. No one in a legitimate business strives to constantly lose money.
Keep these actions in mind and you can avoid a lot of potential trouble with any side venture or business you engage in that does not make money right away.