For-profit or for Hobby
By R. DAN FESLER
The IRS can reclassify
taxpayer activities from "for-profit" to
"hobby." Hobby classification results in
disallowance of losses and an associated tax
deficiency. To establish a profit motive,
taxpayers must demonstrate that the predominant,
primary or principal objective of the activity
in question is to realize an economic profit.
"All facts and circumstances" relevant to an
activity are considered in making the
"for-profit" call but the IRS focuses on the
nine factors discussed below. Law makes clear
that these factors are not totally exhaustive
and that satisfying a majority of these factors
will not automatically assure classification as
"for-profit." Still, knowing and planning around
these factors can be key to maintaining loss
Manner of Carrying on the Activity. For-profit
activities entail "businesslike" operations as
well as maintenance of complete and accurate
books and records. Per tax law, the entrepreneur
of a for-profit activity uses records to make
prudent operational changes, adopt new
techniques, and abandon unprofitable methods.
For-profit activities generally involve
advertising, maintaining separate bank accounts,
developing written business plans, and a
plausible strategy for earning a profit.
Interestingly, out-of-date business cards have
been cited as indicative of lack of profit
Expertise of the Taxpayer. Extensive study of an
activity including its accepted business,
economic, and scientific practices, may indicate
a profit motive. The IRS looks at formal
training and experience as well as continuing
education activities in accessing expertise.
Consultation with experts may also indicate a
profit motive. However, simply meeting with a
Certified Public Accountant (CPA) to discuss tax
issues is not considered consultation with an
expert for purposes of this factor.
Time and Effort. For-profit activities generally
entail significant time commitments.
Nevertheless, when the activity has significant
personal and recreational components (e.g. horse
training, music activities, etc), time spent may
not be indicative of profit motive.
However, devoting only limited time to an
activity does not necessarily, indicate lack of
a profit motive.
Assets May Appreciate. Where assets used in the
activity may appreciate in value sufficiently to
lead to an overall profit when netted against
losses, profit motive may be present. However,
per the Tax Court,deductions cannot be allowed
forever for unprofitable farming, horse-breeding
and other land based operations due to
appreciation in associated land values.
Success in other similar or dissimilar
activities and history of income or loss. The
IRS will consider taxpayer success in similar
activities. Specifically, whether you operate
the activity in question similar to the
operation of other profitable activities. While
the IRS sometimes recognizes that a period of 5
to 10 years is required to achieve
profitability, such "startup" period does not
Occasional Profits and Financial Status of
Taxpayer. Substantial occasional profits are
generally indicative of a profit motive where
losses are comparatively small. A realistic
belief of profit in a highly speculative
activity may also suggest a profit motive.
Having significant financial resources from
other activities may indicate lack of profit
Elements of Personal Pleasure or Recreation. The
presence of personal pleasure or recreation may
indicate lack of a profit motive. Such is common
in many activities including horse
raising/breeding, coin collecting, and music.
However, the fact that there may be associated
personal pleasure or recreation does not
necessarily indicate lack of a profit motive if
other factors suggest the presence of a profit
Where the totality of facts and circumstances
suggest lack of a profit motive, or a hobby
activity, all is not necessarily lost.
Deductions can be preserved via the Tax Code's
presumption that an activity is engaged in for a
profit, if there is profit in three out of five
consecutive years (three of seven consecutive
years is required for activities involving
Planning around the nine factors mentioned above
enhances a taxpayer's ability to preserve
In many cases however, timing expenses and
income to show even a small profit in 3 of 5
years (3 of 7 for horses) may be the best
strategy to preserve all your deductions.
But if you cannot meet this rule and the IRS
labels your activity a hobby, you still may be
able to deduct your expenses up to the amount of
income you generate from the activity.