The IRS distinguishes between activities conducted for profit and those deemed hobbies, and this distinction is crucial when it comes to what deductions are allowed for losses from the activity. Losses from hobbies are only deductible up to the amount of income generated by the activity itself. This means that if an activity is classified as a hobby, the losses from the activity can’t be used to offset other income. Losses from a business are not subject to this same limitation.  

To help avoid hobby loss limitations and maximize tax benefits, we’ve outlined key factors that help demonstrate an activity is more than just a hobby. The IRS uses several factors to determine whether an activity is conducted with a profit motive, and each factor is considered in light of all the facts and circumstances surrounding the activity. No single factor will determine whether the activity is a hobby or a business, but the combination of these elements can indicate what the activity is.

1. Carrying on the Activity in a Businesslike Manner

One of the first things the IRS looks at is how the activity is managed. If accurate business records are maintained, detailed financial statements are kept, and the activity is operated in a structured, professional manner, it’s more likely to be considered a business. If the activity is carried on the way similar businesses are it is also more likely to be considered a business. 

2. Expertise and Advice

The level of expertise of the individual conducting the activity or the expertise of those consulted can play a significant role in determining whether the activity is a business. If the individual carrying on an activity takes steps to educate themselves on the activity and how to make it profitable—whether through formal training, research, or by seeking professional advice—they are demonstrating an intention to turn the activity into a successful business. Acting contrary to expert advice could indicate that the activity is for recreation unless it is demonstrated that the activity is being conducted that way to develop new techniques that could lead to a profit in the activity. 

3. Time and Effort Invested

The time and energy invested in the activity is another strong indicator of whether it’s a business. If significant personal time and effort is dedicated to the activity, especially to the exclusion of other occupations, this suggests a profit motive. If competent and qualified individuals are employed to dedicate significant time to the activity this may also indicate the activity is a business. On the other hand, if only a limited amount of time is spent on the activity it may be a hobby. 

4. Expectation of Asset Appreciation

Another factor that suggests an activity is a business is whether it is expected the assets involved in the activity will increase in value. For instance, if an activity involves purchasing land that is expected to appreciate over time, this can indicate a profit motive.  

5. History of Success in Similar Activities

If similar activities were previously undertaken that were turned profitable, that history can suggest that the current activity is for profit. The ability to succeed in similar ventures makes it more likely that the current pursuit is also aimed at earning a profit. 

6. Profit and Loss History

A history of consistent losses, particularly if those losses continue beyond what’s considered the normal startup phase for the activity, can indicate that the activity is not engaged in for profit. However, a pattern of earning income strongly supports the idea that the activity is a business. 

7. Occasional Profits

Even occasional profits can play a role in demonstrating a profit motive. If the activity generates only occasional profits but significant losses, this could signal the activity is a hobby. Conversely, significant occasional profits in an activity with a high stakes nature, may indicate the activity is a business. 

8. Financial Status

The financial status of the individual conducting the activity is also relevant. If the activity is the primary source of income or is depended on for support, it’s a strong indicator that it is a business. If, however, the individual engaging in the activity is generating substantial income from other sources the activity may be a hobby. 

9. Personal Pleasure or Recreation

Lastly, if the activity is conducted for personal enjoyment or recreation, that could suggest it’s not a business. It is acknowledged that it’s not unusual for business owners to find enjoyment in their work, but if personal pleasure is the primary motivator and profit is secondary, it’s more likely for the activity to be considered a hobby. However, just because the activity is enjoyable does not automatically mean it’s a hobby—if the activity is organized and managed like a business, other factors may outweigh the personal pleasure consideration. 

Conclusion 

The distinction between a business and a hobby can have a significant impact on tax obligations. The IRS considers a range of factors when determining whether an activity is conducted for profit including but not limited to the factors above. By demonstrating a clear profit motive the argument that the activity is a business is more likely to succeed. If you are starting a new business, we can work with you to make sure you’re treating your activity like a business, ensuring you can claim all business deductions. 

By: Cedar Bauer, Esq., Tax Research Associate