Is My Business a Business or Hobby?Hobby Loss Rules

Taxpayer View Taxpayers want everything to be a business if it

will help them reduce their taxes

IRS View They would rather categorize an entity as a hobby

if it is losing money Hobby losses are limited

Expenses are limited to revenues Reported on Sch. A subject to a 2% floor

Example: If Photography is Hobby not Business You get paid $2,000 Expenses are $4,000 Your and your spouses AGI is $50,000

You show the $2,000 on your 1040 as other income. You are limited to $2,000 in expenses. However, your

2% floor is $1,000 (50,000 x 2% = $1,000). Thus, you only get to deduct $1,000 ($2,000-$1,000 = $1,000).

And you only get to take that if you itemize!

Example Continued If it were a business you would get to show a

$2000 loss on Schedule C ($2,000 - $4,000 = $2,000 loss).

If it is a hobby, you still have to report the income. However, you might not get to deduct any

expenses if you don’t itemize. Even if you do, you only get to deduct $1,000 of the expenses.

Business vs. Hobby If you show a profit 3 out of 5 years, the basic

presumption of the IRS is that you are a business. This is not a hard and fast rule.

Some businesses show losses more than 2 our of 5 years The basic idea is that if you have a profit motive, you

will quit if you continue to show losses

Note: Farms only have to show profits 2 out of 7 years

Profit Motive: The Real Key It really comes down to do you have a profit motive

or is it just a hobby. Many small businesses do things they love. E.g.,

photography. But the bottom line is are you trying to develop it into a successful business

Other factors Time involved Are you trying to change your operations to increase

profit

Conclusions and Disclaimer: Taxpayers generally want to avoid the “hobby”

designation A business that continues to show large losses,

the IRS may want to re-categorize as a hobby. This is a somewhat superficial overview – talk to

your tax preparer if you have specific questions or contact us at derland@dbahrcpa.com to discuss your specific issues.