Sunday, September 20, 2009

Hobby Losses: How Does the IRS Decide If Your Business Is a Hobby?

The determination as to whether an activity is a business or a hobby in the eyes of the IRS is ultimately based on the specific facts and circumstances. There is no simple definition to be applied to classify an activity as a hobby. Rather, the Internal Revenue Code and Treasury Regulations serve as guidelines for making the hobby vs. business determination.

Whether or not an activity is a business or hobby is ordinarily determined by analyzing 9 factors found in the Treasury Regulations. Knowing what these factors are in advance can help a business owner plan and take certain steps to overcome any hobby loss question that arises.

The factors are:

1. The manner in which the taxpayer carried on the activity.
2. The expertise of the taxpayer or his or her advisers.
3. The time and effort expended by the taxpayer in carrying on the activity.
4. The expectation that the assets used in the activity may appreciate in value.
5. The success of the taxpayer in carrying on other similar or dissimilar activities.
6. The taxpayer’s history of income or loss with respect to the activity.
7. The amount of occasional profits, if any, which are earned.
8. The financial status of the taxpayer.
9. Elements of personal pleasure or recreation.

It is important to mention that no single factor controls and that other factors may be considered. The mere fact that the number of factors indicating the lack of a profit objective exceeds the number indicating the presence of a profit objective (or vise versa) is not conclusive. That is, it is not a question of just adding up how many factors fall on the hobby or business side of the maths.

Unless the presumption discussed in my last hobby loss post applies, the taxpayer has the burden of proving that these factors establish the activity at issue is engaged in with an actual and honest objective of realizing a profit.

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