Updated: Jan 14, 2019
When you first start a business, the first few years are very important. During this time frame, it will become determinant if a business will succeed or fail. Unfortunately, not every business will turn a profit in its first few years. To make matters worse, the losses might be disallowed in what is known as the Hobby Loss rule. When a business has continuous losses, the IRS often turn to what is known as the Hobby Loss rule.
What is the Hobby Loss rule?
Losses result when expenses exceed income. If you operate a business, your business losses can offset other income on your return. However, if your activities are determined to be those of a "hobby," you can only deduct hobby expenses up to the amount of your hobby income. Expenses that exceed income are nondeductible personal losses.
Where the confusion lies:
Most taxpayers will overlook this rule and simply take their losses year after year. After all, business losses can be used to offset individual income. Due to this potential abuse, the line between what the IRS considers to be a hobby versus a business activity is not clear. In making the distinction between a hobby or business activity, the taxpayer should take into account all facts and circumstances with respect to the activity.
Whether you carry on the activity in a businesslike manner and maintain complete and accurate books and records.
Whether the time and effort you put into the activity indicate you intend to make it profitable.
Whether you depend on income from the activity for your livelihood.
Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
Whether you change your methods of operation in an attempt to improve profitability.
Whether you or your advisors have the knowledge needed to carry on the activity as a successful business.
Whether you were successful in making a profit in similar activities in the past.
Whether the activity makes a profit in some years and how much profit it makes.
Whether you can expect to make a future profit from the appreciation of the assets used in the activity.
There are some good news. The limit on hobby losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations. Thus, corporations are not subjected to this limitation. Recall from the Choice of Entity video, we discussed that various factors should be reviewed before selecting one choice of entity over the other—this is one of them.
The IRS presumption:
The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year — at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses. Thus, the burden of proof then lies with the taxpayer (or the taxpayer representative) to make a convincing case.
We specialize in helping our clients with their tax audits. At Le Tax law, we will be with you every step of the way.
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