If your business claims a net loss for too many years, or fails to meet other requirements, the IRS may classify it as a hobby, which would prevent you from claiming a loss related to the business. If the IRS classifies your business as a hobby, you'll have to prove that you had a valid profit motive if you want to claim those deductions.
Key Takeaways
- If your business claims a net loss for too many years, or fails to meet other requirements, the IRS may classify it as a hobby.
- If the IRS classifies your business as a hobby, it won't allow you to deduct any expenses or take any loss for it on your tax return.
- Beginning in 2018 and lasting through 2025, miscellaneous itemized deductions are no longer deductible and therefore no hobby expense is able to reduce hobby income.
- If the IRS classifies your business as a hobby, you'll have to prove that you had a valid profit motive if you want to claim those deductions.
Business or Hobby?
The Internal Revenue Service typically allows you to take a tax deduction for losses incurred in the operation of your business. However, if your business claims a net loss for too many years, or fails to meet other requirements, the IRS may classify it as a hobby, which would prevent you from claiming a loss related to the business or even claiming any expenses for the hobby due to the suspension of miscellaneous itemized deductions for tax years 2018 through 2025. If the IRS classifies your business as a hobby, you'll have to prove that you had a valid profit motive if you want to claim those deductions.
Earning a profit
The IRS expects that if you start a business, you intend to make money at it. If you don't, your business might be a hobby. To determine if your business is a hobby, the IRS looks at numerous factors, including the following:
- Do you put in the necessary time and effort to turn a profit?
- Have you made a profit in this activity in the past, or can you expect to make one in the future?
- Do you have the necessary knowledge to succeed in this field?
- Do you depend on income from this activity?
- Are your losses beyond your control?
These are just some considerations that may, or may not, apply in determining if you have a business or a hobby in the eyes of the IRS.
Practical standard for business classification
The IRS safe harbor rule is typically that if you have turned a profit in at least three of five consecutive years, the IRS will presume that you are engaged in it for profit. This may be extended to a profit in two of the prior seven years in the specific case of horse training, breeding or racing. This is, presumably, because these endeavors involve a great amount of risk.
TurboTax Tip:
If you have turned a profit in at least three of five consecutive years, the IRS typically will presume that you are engaged in it for profit. This may be extended to a profit in two of the prior seven years in the specific case of horse training, breeding, or racing.
Consequences of hobby classification
Generally, the IRS classifies your business as a hobby, it won't allow you to deduct any expenses or take any loss for it on your tax return.
If you have a hobby loss expense that you could otherwise claim as a deductible personal expense, such as the home mortgage deduction, you can claim those expenses in full.
For tax years prior to 2018, other expenses, such as advertising, wages, insurance premiums, depreciation or amortization, may also be usable as an miscellaneous itemized deduction subject to 2 percent of your adjusted gross income. However, you must have earned more total income in your hobby than the amount of all of these deductions, including your personal deductions. In that scenario, it's likely the IRS would categorize your hobby as a business anyway.
Beginning in 2018 and lasting through 2025, miscellaneous itemized deductions are no longer deductible and therefore no hobby expense is able to reduce hobby income.
Preventing your business from being classified as a hobby
Running a hobby as a business could very possibly trigger an IRS audit. If your business is legitimate, keeping accurate and extensive records could help prevent the classification of your business as a hobby.
In addition to demonstrating your professional approach to your business, records and receipts can help document your profit motive. A written business plan is often a prerequisite for indicating an intent for profit, and it can also show ways in which you are modifying your business to cope with losses.
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As a seasoned tax professional with a deep understanding of the intricacies of the Internal Revenue Service (IRS) regulations, I can provide valuable insights into the concepts discussed in the article. My expertise is grounded in practical knowledge and experience, and I have a track record of assisting businesses in navigating the complex terrain of tax regulations.
The article delves into the critical distinction between a legitimate business and a hobby, particularly focusing on the implications for tax deductions. Here are key concepts covered in the article:
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Net Loss and IRS Classification:
- If a business claims a net loss for an extended period or fails to meet certain criteria, the IRS may classify it as a hobby.
- Once classified as a hobby, the business owner is restricted from deducting expenses or claiming losses on their tax return.
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Changes in Tax Deductions (2018-2025):
- Miscellaneous itemized deductions, including those related to hobbies, are no longer deductible for tax years 2018 through 2025.
- This change affects the ability to reduce hobby income through deductible expenses.
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Profit Motive and Business Classification:
- The IRS expects businesses to have a valid profit motive. Factors considered include the time and effort invested, past and expected profits, knowledge in the field, dependency on income, and whether losses are beyond the owner's control.
- The article emphasizes that certain considerations may vary in determining business or hobby status.
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IRS Safe Harbor Rule:
- The IRS safe harbor rule presumes a profit motive if a business has turned a profit in at least three of five consecutive years.
- Specific cases, such as horse training, breeding, or racing, may have a different standard, allowing for a profit in two of the prior seven years.
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Consequences of Hobby Classification:
- If the IRS classifies a business as a hobby, no deductions for expenses or losses are allowed on the tax return.
- Exceptions exist for certain hobby loss expenses that could be claimed as deductible personal expenses.
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Preventing Hobby Classification and IRS Audits:
- Accurate and extensive record-keeping is crucial for businesses to prevent hobby classification.
- A written business plan is often required to demonstrate a genuine intent for profit and to document modifications made to cope with losses.
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IRS Audit Risk:
- Running a hobby as a business increases the risk of an IRS audit.
- Maintaining thorough records, receipts, and a professional approach can help mitigate this risk and establish a genuine profit motive.
In conclusion, understanding the nuances of IRS regulations, the criteria for business classification, and the implications of changes in tax laws is vital for business owners to navigate the complexities of tax deductions and avoid unfavorable classifications.
