If you own a side or hobby-type business for fun and profit, to deduct expenses under IRS rules you need to pay close attention to trying to make a profit – or at least seeming to try.
Note: consecutive losses for three or more years may trigger IRS scrutiny.
Tax deductions can be disallowed for enjoyment or hobby-motivated businesses if the owner has not demonstrated to the IRS’s satisfaction what could be termed a good-faith attempt to make money.
Under tax rules such a business can find itself reclassified by the IRS as “an activity not engaged in for a profit”, a fancy term for a hobby. In such cases, revenue must be recognized as income for tax purposes but miscellaneous expenses that in the past could be deducted are no longer deductible. One of the changes made by the Tax Cuts and Jobs Act was the elimination of miscellaneous itemized deductions, which is where these types of expenses were allowed previously.
The nine factors the IRS uses to reach its conclusions, each with its own determining elements, are:
- 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.
One example: a successful architect who enjoys fishing starts a charter boat business on the side. If he or she is loosey-goosey about record keeping; generating new charter bookings; loses money; and doesn’t spend a demonstrable amount of time and effort trying to get the operation in the black, there’s a good probability business-related deductions will be disallowed.
A second example: A person running a horse stable invested substantial money to make it a first-class operation. Revenue, however, was not covering operating costs let alone depreciation. Though several of the nine factors were met, several weren’t such as being profitable one out of three years. That issue alone now puts deductions into the “problematic” category. In their case, the IRS said that expected future profits when assets were sold would have been sufficient to allow the losses, except they could not demonstrate expected future profits based on current appraisals.
Furthermore, in such a situation if it can’t be definitively shown how much time – not just money – was spent on trying to make it profitable, that’s another deductibility problem.
If you have an unprofitable business venture, you must exercise caution. The losses from such a venture could be seen as "sheltering" large amounts of income from other sources. If you want to deduct these losses, consider:
- A written business plan (and stick to it!)
- Consult with experts in a field that relates to your venture
- Make changes to how you operate, sufficient to show that you are indeed trying to make a profit
- If all else fails, cut your losses by closing and selling the venture
Also, if you’re relying on the ninth factor – expecting to make a future profit from the asset's appreciation used in the activity – keep a weather eye on the appraisals of those assets. If they fall short of what you expected, you’ll fail that test. Be sure those assets, the appreciation of assets used in the venture, are indeed appreciating.
The reason for the IRS’s nine factors and accompanying regulations is because Uncle Sam isn’t going to be denied his piece of the tax pie because an owner didn’t appear to be – in the IRS’s view – working hard enough to turn a profit and thus taking tax deductions to boot.
That’s why criteria were established to ensure such businesses are at least trying to make money as the IRS defines trying to make money, or working in a businesslike manner toward being profitable. Arguments between the IRS and taxpayers can wind up in Tax Court, examples of which are available in this edition of the Journal of Accountancy.
Those are the (IRS’s) rules to live by.