Many taxpayers have side gigs that have a significant impact on their taxable income. From Uber drivers, to carpenter contractors, to horse racing, to manufacturer reps, to part-time real estate agents, to organic beef farms… you name it, and we’ve probably seen it.

 

And from a tax-compliance standpoint, there is an important distinction between hobbies and businesses that are operated with the intention of earning a profit. Understanding this distinction could save you thousands of dollars come April 15th.

 

Hobby Loss Rules: If an activity is not intended to earn a profit, losses from that activity may not be used to offset other income.

 

The ability to deduct losses on your tax return will ultimately be determined by the Internal Revenue Service. If the IRS determines that the taxpayer did not enter into the business activity with a profit motive or that the taxpayer continued losing money in an activity with no intention of ultimately making a profit, the taxpayer will lose the ability to deduct those losses. These rules apply to individuals, partnerships, estates, trusts, and S corporations.

 

Hobby or For-Profit Business? When determining the real intent of the taxpayer’s activity, the Internal Revenue Services will look at a number of factors in assessing whether or not the activity is motivated by profit:

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1. whether the activity is conducted in a professional, businesslike manner

2. the qualifications of the taxpayer or the taxpayer’s advisors

3. the amount of time and effort spent by the taxpayer or the competency of the taxpayer’s agents and employees

4. the potential for appreciation of the venture’s assets

5. the taxpayer’s history in operating other businesses

6. the taxpayer’s success or failure with the particular activity

7. the ratio of profits to losses and how that compares to the taxpayer’s investment in the enterprise

8. the financial status of the taxpayer, the economic benefit of the losses, and the taxpayer’s primary source of income

9. the personal pleasure or recreation the taxpayer derives from the activity

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While the taxpayer must engage in the activity with a genuine profit motive, a “reasonable” expectation of profit is not required if the probability of loss is much higher than the probability of gain.

 

The IRS will likely view all the facts and circumstances to make their decision, but more weight is given to objective facts than taxpayer statements. One simple way to get off the radar screen of the IRS is to show a profit. If the gross income from the activity exceeds deductions for three out of 5 years, the activity is presumed to be conducted for profit.