Federal IRS Rules for your Hobby type Business
Post the 3-out-of-5-year rule and taxpayer misconceptions
When it comes to the question, Is it a Business or a Hobby? The Internal Revenue Service (IRS) has established an administrative rule regarding their presumption of profit: An activity is presumed to have a profit motive if it produces a profit in at least 3 of the past 5 tax years including the current year. Publication 535: Business Expenses, IRS, p. 6.
This is merely an administrative rule used internally by the IRS. It does not have the effect of statutory law and it does not follow that an activity failing to produce a profit in at least 3 out of 5 years will be presumed to a not-for-profit activity. Yet many taxpayers have this misconception. No single factor constitutes evidence of profit motive, although some have evolved from case law and have been adopted by the IRS.
What is a hobby?
A hobby is an activity not engaged in for profit. The term hobby suggests an activity that is personal and recreational in nature. It is unlikely that an electrician would be concerned about having his/her business classified as a hobby. Alternatively, a skydiving instructor, who also engages in this sport for personal pleasure or recreation, may be a more likely candidate for IRS scrutiny and hobby loss classification.
A key feature of a Business is that people do it to make a profit. Also, people usually engage in a hobby for sport or recreation, not to make a profit. Consider nine factors when determining whether an activity is a hobby. Make sure to base the determination on all the facts and circumstances. For more about ‘not-for-profit’ rules, see Publication 535, Business Expenses.
Furthermore, in making the distinction between a hobby or Business activity, take into account all facts and circumstances with respect to the activity. A hobby activity is done mainly for recreation or pleasure. No one factor alone is decisive. You must generally consider these factors in determining is it a Business or a hobby, whether an activity is a Business engaged in making a profit:
Do you carry on the activity in a businesslike manner and maintain complete and accurate books and records?
Whether the time and effort you put into the activity indicate you intend to make it profitable. 500 Hours Minimum
Do you depend on income from the activity for your livelihood?
Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
Do you change your methods of operation in an attempt to improve profitability?
Whether you or your advisors have the knowledge needed to carry on the activity as a successful business.
Are you being successful in making a profit in similar activities in the past?
Whether the activity makes a profit in some years and how much profit it makes.
Can you expect to make a future profit from the appreciation of the assets used in the activity?
Allowable hobby deductions.
Taxpayers can usually deduct ordinary and necessary hobby tax expenses within certain limits:
Ordinary expense is common and accepted for the activity.
Necessary expense is appropriate for the activity.
Limits on hobby expenses.
Taxpayers can generally only deduct hobby expenses up to the amount of hobby income and only on Schedule A. If hobby expenses are more than its income, taxpayers have a loss from the activity. However, a hobby loss can’t be deducted from other income.
How to Deduct Hobby Expenses
Taxpayers must itemize deductions on the Schedule A of their Tax return to deduct hobby expenses. Expenses may fall into three types of deductions, and special rules apply to each type. See Publication 535 for the rules about how to claim them on Schedule A, Itemized Deductions.
For some reason, people who have a full time W2 job decide that they want to get involved selling a product or service that they like or use. An example would be Avon or Mary Kay. They sign up to sell these items. Then purchase products at a discount to use and sell to their friends. They may go to meetings that tell them that they can write off their vacations to Florida or Las Vegas as long as they attend the company event. So, at the end of the year their sales were $700, and their expenses were $5300 that they think they can write off. But, on review, they can’t meet all of the qualifications to be a true business (see above).
Therefore, the $700 gets added to their income and -0- expenses get used because they don’t have enough deductions to use the Schedule A. So, don’t start a hobby that pretends to be a business.