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, the chances of an audit may increase if a client fails to declare income and deductions properly.
For federal tax purposes, the income, losses and expenses of a small business are filed on the IRS form Schedule C. Sometimes, taxpayers enjoy gross income from something they consider to be a hobby. The Internal Revenue Code Section 183 allows them to deduct some of the expenses from the activity even without establishing the profit intent that would qualify it as a trade or business.
But 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,” says the IRS in one of its audit technique guides called “Activities Not Engaged in for Profit.”
For an endeavor to be considered a business, it 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 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.
There are other questions taxpayers must answer: Did they make a profit from a similar activity in the past? Does their current endeavor profit in some years? And by how much? The IRS also says a business must show a net profit for three out of its first five years of operation, otherwise the agency considers it 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,” says 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 audit technique guide adds that examiners should be watching for many other details: Are there several years in which the business records little or no income and large losses? Are large losses being used to offset some other income the taxpayer is recording? Does the business or activity include elements of “recreation and/or personal pleasure”?
Section 183 says that if an activity is a not-for-profit hobby, then the taxpayer can’t take deductions for it. However, there are still some instances where they can treat it as a for-profit business, for instance if the gross income from the activity exceeds the deductions in three of five consecutive years.
Blogger Leslie Book recently tackled this subject on the Procedurally Taxing website, and said wealthy people taking Section 183 hobby losses could draw more IRS scrutiny “when wealthy taxpayers try their hand at boat chartering in the Caribbean, dressage, running a vineyard, or writing a travel guide premised on finding the best sushi in Japan, and the activities generate losses that the taxpayer would like to use to offset other income.”
Book continued, “Given the temporary disallowance of all miscellaneous itemized deductions [in the wake of 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 those 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 to the IRS, and much of that was earmarked for enforcement.
The Treasury inspector general for tax administration office recently said it found indications in a large percentage of Schedule C forms that the “businesses may not have been engaging in the activity for the primary purpose of making a profit.”
That means it’s essential that clients work with a tax pro if they are starting ventures that make income.
“Many of our clients know to make us their first resource when starting a new venture,” Hanover says. “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. … 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.”