Duvall & Associates, Inc.
BUSINESS ADVISOR NEWSLETTER
 

Don't let the IRS declare your business as a hobby

- by Alan Duvall 

Published in Dayton Daily News June 18, 2006 

Nirvana at work is a wonderful thing – but beware of having too much fun or your business could become a tax demon labeled a HOBBY. 

Companies can deduct without limitation all expenses incurred for legitimate business purposes.  But if a business frequently bleeds red ink, it risks alternative classification as a hobby, thereby suffering severe restrictions on expense deduction. 

A hobby is negatively defined as any activity not engaged in for profit and can thereby afflict many industries not normally associated with pleasure such as farms, asset rentals and casual sales of home products.

IRS Regulations list nine definitional criteria to be considered in determining business versus hobby status.  Listed factors include businesslike operations and bookkeeping efforts, taxpayer expertise and time expended, as well as elements of personal pleasure inherent in the activity.  As usual, documentation of business intent is key. 

A rebuttable presumption exists an activity is conducted for profit if it earns positive net income in three out of five consecutive years.  Horse farms enjoy special legislative status to earn a five out of seven year test. 

 This test is presumptive only – no guarantees.  If met or not the conclusion is not written in stone – results only shift the relative burden of proof in the controversy.  Thus, even constant losers can avoid the hobby tag and justify the deductible realm of business status.  Nevertheless, cash basis taxpayers would be wise to maneuver income and expenses to generate profits in three out of five years thus taking the wind out of IRS audit sails.   

Taxpayers have the right to file Federal Form 5213 to request a postponement of hobby determination until the fourth (sixth for horses) year of the test period.  Such a request is obviously a red flag to the IRS and extends the statute of limitations period with regard to tax issues affected by determination of hobby status.

 If proscribed a hobby, related expenses can only be deducted to the extent of hobby income.  Initially, gross income is reduced by expenses deductible without regard to business status such as itemized interest and taxes.  Additional activity expenses can thereafter be deducted until net profit is reduced to zero.  

Summarily, if engaged in an activity at risk of being a non-deductible hobby – document business intent and attempt to achieve positive profits in three out of five years.  

All work and no play make Jack a deductible boy.

Alan Duvall is a certified public accountant in Dayton.  Contact him at Alan@Duvallcpa.com.