Monday, August 31, 2009

Hobby Losses: Background.

As most business owners will tell you, the Internal Revenue Code allows a business to deduct expenses which are incurred in a trade or business or for the production or collection of income. However, for these expenses to be fully deductible the activity must be engaged in with the intention of making a profit. That is, the activity must be a business and not a hobby.

Internal Revenue Code Section 183 contains the general principle of the hobby loss rule. Section 183 limits expense deductions if the business under scrutiny is determined not to be engaged in for profit. An “activity not engaged in for profit” means “any activity, other than one with respect to which expense deductions are normally allowed.” This unhelpful definition does little to tell a business owner what they need to do to avoid being classified as a hobby. One must turn to the related Treasury Regulations to understand how this rule is applied.

Later posts to this blog will shed more light on the factors used in considering the hobby issue. Before discussing the factors, however, it is helpful to know the impact of a business being reclassified as a hobby. In general, if a business is determined to be a hobby, any deductible expenses of the activity will be limited to the amount of income from the activity. This means that the activity cannot generate losses to offset other income shown on a tax return.

As an example, assume that a taxpayer has a day job and a side business. The side business has yet to be successful and has suffered losses for the last 5 years. Those losses were reported on a tax return and reduced the overall taxable income of the taxpayer such that he/she receives a substantial tax refund year after year. If the IRS determines that the side business is really a hobby, all of those losses will be denied. This means that the day job income will no longer be reduced by the losses and the previously offset income will be subject to tax…and penalties…and interest.

No comments: