Treading the line between a hobby and a business on tax forms has always been tricky. With the IRS pledging more attention to wealthy taxpayers, chances of an audit may increase if a client fails to declare income and deductions properly.
For federal tax purposes, small-business income, losses and expenses are filed on the IRS Schedule C, “Profit or Loss From Business (Sole Proprietorship).” Taxpayers may also have gross income even from a hobby; Internal Revenue Code Section 183 allows taxpayers to deduct some of the expenses from the activity even without establishing the profit intent to merit the activity qualifying as a trade or business.
That line can be blurry. “It can often prove highly difficult to figure out the difference between a legitimate business that is devoted to making a profit and an activity that is not,” reads the IRS “Activities Not Engaged in for Profit Audit Technique Guide.”
For an endeavor to be considered a business, the activity has to be carried out “in a businesslike manner” with “complete and accurate books and records,” says the IRS; the taxpayer must put in time and effort “to show they intend to make it profitable”; and the taxpayer has to depend on income from the activity for their livelihood. Taxpayers also have to consider whether any losses were beyond their control or were normal for the startup phase of their business.
Did the taxpayer make a profit in similar activities in the past? Does the current activity profit in some years, and by how much? The IRS also says a business must show a net profit for three out of the first five years of operation or be considered a hobby for tax purposes.
“Most people are preoccupied and focused on the three-out-of-five-year rule, but that’s only one factor,” said Joshua Hanover, a CPA, enrolled agent and managing director and office lead at CBIZ Marks Paneth in Boca Raton, Fla. “It’s important to grasp not only what activity [clients are] doing but why they’re doing it. The same activity for one person [could be] a business, yet for another it’s a hobby.”
The IRS “Profit Audit” adds that examiners should watch for several years with little or no income and large losses; minimal income and large expenses for several years and if losses offset other income; and if the business or activity includes elements of “recreation and/or personal pleasure.”
“Boat chartering in the Caribbean, dressage, running a vineyard, writing a sushi guide of Japan—with the IRS promising more unwelcome attention to wealthy taxpayers, will hobby loss/Section 183 cases soon increase?” the blog "Procedurally Taxing" recently said. “Given the temporary disallowance of all miscellaneous itemized deductions (due the Tax Cuts and Jobs Act), the stakes are even higher when a taxpayer is deemed to not have the requisite profit intent.”
In recent years federal audits have doubled for wealthy taxpayers and taxpayers earning more than $10 million saw their audit rate jump four times, to 8%, the agency said. The Inflation Reduction Act of 2022 allocated some $80 billion for enhanced IRS enforcement, much of that earmarked for enforcement.
The Schedule C has been the basis for reports from the Treasury inspector general for tax administration that a large percentage of such tax returns “reflected indications that Schedule C businesses may not have been engaging in the activity for the primary purpose of making a profit.”
Working with a tax pro is essential on this question.
“Many of our clients know to make us their first resource when starting a new venture. We keep our clients well informed and provide perspective for them [but] prospective clients and referral sources are filled to the brim with misunderstandings and bad advice,” Hanover said. “Whether it’s something they Googled, saw posted on social media, their friend told them or that came up on their TikTok feed, they fail to understand the nuance of their own situations We spend a significant amount of time educating people and myth-busting.”