The IRS sometimes questions whether a business that has historically generated losses is actually a business, or if it is instead a hobby. The distinction is very important, as business losses are deductible against ordinary income, while a hobby cannot generate a loss. Whether or not the losses from an activity are deductible as a business loss depends on the taxpayers profit motive.
Questions or concerns about being audited by the IRS or your taxes? Contact a Sacramento tax lawyer of NewPoint Law Group, LLP.
Profit Motive Factors
It is a common misconception that if a business has a loss in three out of five years, it will automatically be deemed a hobby by the IRS. However, this misapplied concept is merely one of many factors used in determining whether the taxpayer has a profit motive. Treasury Regulation 1.183-2(b) provides nine factors used in determining whether an activity has a profit objective:
- The manner in which the taxpayer carries on the activity. If a taxpayer carries on an activity in a businesslike manner, such as keeping accurate books and records, it is indicative that the activity is operated for profit.
- The expertise of the taxpayer or the taxpayer’s advisors. If the taxpayer is an expert in the field, such as a head chef opening a new restaurant, it is more likely that the taxpayer had a profit motive. If the taxpayer is not an expert, consulting with outside advisors is indicative of a profit motive.
- The time and effort expended by the taxpayer in carrying on the activity. If the taxpayer puts forth significant time and effort into an activity, it may indicate a profit motive. Note that it does not require the taxpayer to engage solely in the activity in question.
- The expectation that the assets used in the activity may appreciate in value. If a taxpayer expects business assets to increase in value, ultimately leading to a profit, it is more likely to be a profit motive.
- The success of the taxpayer in carrying on similar activities. If a taxpayer has been successful in a related field, it is more likely that the taxpayer has a profit motive.
- The taxpayer’s history of income or losses with respect to the activity. This factor is often confused with the rule; however, a history of losses by itself does not disqualify a taxpayer from having a legitimate profit motive. History of losses is only one of many factors to be considered from a global perspective.
- The amount of occasional profits, if any. An occasional small profit in an activity that generates large losses may indicate a lack of profit motive, but the potential to earn a substantial ultimate profit in a highly speculative venture is sufficient to indicate the existence of a profit motive.
- The taxpayer’s financial status. A taxpayer with modest means is likely to rely on income generated from a particular activity, which may be indicative of a profit motive. Though, even for taxpayers with means, this factor in practice is often not determinative, and is generally used as support for a conclusion based on other factors.
- Whether the activity contained elements of personal pleasure or recreation. Similar to the eighth factor, elements of personal pleasure by themselves are insufficient classify an activity as not for profit, but instead are used as support for a finding based on other factors.
Contact a Sacramento Tax Lawyer of NewPoint Law Group, LLP
If your business is generating losses, it is important to recognize the risk of an IRS audit that may deem an activity as a hobby. Understanding the factors in making that determination can help avoid such an undesirable result. Many of the factors may be out of your control, yet you do have control over the first three factors. Be sure to treat the activity like a business by developing a business plan, maintaining adequate books and records, putting in the time and effort necessary to succeed, and seeking the advice of experts as needed. Speak with an experienced Sacramento tax audit attorney of NewPoint Law Group, LLP.