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Tax tips: For-profit or for Hobby

 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 deductions.

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 Interestingly, out-of-date business cards have been cited as indicative of lack of profit motive.

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 run indefinitely.

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 motive.

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 motive.

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 horses).

Planning around the nine factors mentioned above enhances a taxpayer's ability to preserve deductions.

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.

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