Avoiding “Hobby Loss” or “Not-For-Profit” Classification

Self-employed taxpayers often need to prove whether deductions listed on their Schedule C tax returns are from business expenses rather than personal expenses.  On many occasions taxpayers will write off personal endeavors on their Schedule C forms to reduce their taxes overall, this can cause trouble.  Laws have been created to prevent a taxpayer from taking deductions on their Schedule C and other forms for activities they engage in that are not associated with a profit.  To reduce this risk of fraudulent tax return, I will go over some key points and restrictions to be aware of.  First, what is a hobby?  A hobby is an activity that is not an endeavor for profit but rather an activity that is personal and for entertainment purposes.  With this in mind, a reasonable taxpayer would not take expenses from their hobby and try to deduct them on a tax return Schedule C or any form of the like.

The Internal Revenue Service has established an administrative rule presuming that that an activity with a profit motive producing a profit in at least 3 out of the past 5 years including the current years in a business and is an appropriate tax write off.  Yet, this is only an administrative rule used by the IRS and does not mean that a business not producing profits 3 out of 5 years is assumed to be a not-for-profit hobby.  To be safe in following IRS and state guidelines, I will go through some basic requirements and factors that every business needs to use.

First, is your endeavor carried on in a business-like manner?  For example, do you prepare monthly, quarterly, semi-annual or annual profit and loss statements?  As well, you should be preparing forecasts or projections.  These do not have to be expert historical analyses, as long as evidence can be shown; the activities receipts and notes can be put in a shoebox and suffice.  Another thought to keep in mind is if the time and effort put into the endeavor suggest a profit-motive.  The taxpayer should keep some sort of log or record of time expended of the activity.  Does the taxpayer depend on this activity for his/her livelihood?  If so, is this full-time?  Or, is the taxpayer work part-time and uses the salary from employment to finance the start-up activity?  If this is the case, then the self-employment activity is producing tax losses and in turn reduces the taxable income.

A taxpayer can experience losses beyond their control.  If operating costs such as gasoline and minimum wage increase and the economy declines resulting in fewer services rendered for clients, these external economic conditions will result in tax loss.  Yet, it is unreasonable for a taxpayer to rely on such externalities year after year.  Another profitable business technique is modifying operating methods to improve profitability.  If a taxpayer has generated tax losses for five consecutive years and during this time period has made no effort to alter operations, the taxpayer has not provided sufficient evidence of profit motive and therefore is risking hobby loss classification. 

Possessing expertise in the field of the activity is a key aspect to success in any business.  If you decide to start your own business and have no prior business experience, you are at a high risk for tax loss disallowance from hobby loss classification.  Consulting experts prior to shows a strong motive for profit.  Along with this, similar experiences of success in similar past activities also show strong profit motive for the future endeavor.  If the activity has generated any profit in the past years and profit has grown over time, no matter what the loss generated might be, you are not likely to be at risk for hobby loss classification.  But, if the activity has generated increasing loss and little profit or decreasing profit, you are a favorable candidate for not-for-profit classification.

If you are a taxpayer consistently generating tax losses from your self-employment activities and you purchase and depreciate collectibles with a high probability of appreciation, your credibility of profit-motive is severely low and your risk of hobby loss classification will be extremely high.  An audit by the IRS is practically inevitable; do not engage in this.  All of these ideas will help to keep the IRS auditors away and keep you in a profitable endeavor.  Of course, this was not to legitimize deducting not-for-profit activity expenses and should not be taken as such.  Yet, this is not to dissuade legitimate business deductions that are necessary.  Do what you can to get those deductions, just be smart about it, and use your common sense.

Leah Stall – About the Author:

Leah Stall is a Sophomore at West Chester University of Pennsylvania.