Ryan J. McDonell, CPA, MSA
Tax Manager
Many people dream of turning a hobby into a business. Perhaps you enjoy cooking and would like to market some of your culinary creations. Or maybe you’d like to turn your crafting or photography skills into an income-producing business. 
You probably won’t have any tax headaches if your new business is profitable over a certain period of time. But what if the new enterprise consistently generates losses (your deductions exceed income) and you claim them on your tax return? You can generally deduct losses for expenses incurred in a bona fide business. However, the IRS may step in and say the venture is a hobby — an activity not engaged in for profit — rather than a business. Then your income from the enterprise will be taxable but you’ll be unable to deduct expenses.
Internal Revenue Code (IRC) section 183 – also known as the “hobby loss rule” – limits the losses that can be deducted from income which are attributable to hobbies and other not-for-profit activities. The hobby loss rule applies to activities engaged in by individuals or S corporations and allows some deductions for such activities, but only as provided in the section.
By contrast, if the new enterprise isn’t affected by the hobby loss rules, all otherwise allowable expenses are deductible, generally on Schedule C, even if they exceed income from the enterprise.
(Important note: Before 2018, deductible hobby expenses could be claimed as miscellaneous itemized deductions if they exceeded 2% of the taxpayer’s adjusted gross income. However, because miscellaneous deductions aren’t allowed from 2018 through 2025 under the Tax Cuts and Jobs Act, deductions for hobby expenses are not allowed during that period.)
How to ensure your enterprise is deemed a business
Profitability is a key factor in whether the IRS considers an enterprise a hobby or a business, and there are two ways to avoid the hobby loss rules:
- Show a profit in at least three out of five consecutive years (two out of seven years for breeding, training, showing or racing horses).
- Run the venture in such a way as to show that you intend to turn it into a profit maker rather than a mere hobby. The IRS regs themselves say that the hobby loss rules won’t apply if the facts and circumstances show that you have a profit-making objective.
Proving that you have a profit-making objective involves operating the venture in a businesslike manner. The IRS and the courts will look at the following factors:
- How you run the activity
- Your expertise in the area (and your advisors’ expertise)
- The time and effort you expend in the enterprise
- Whether there’s an expectation that the assets used in the activity will rise in value
- Your success in carrying on other activities
- Your history of income or loss in the activity
- The amount of any occasional profits earned
- Your financial status
- Whether the activity involves elements of personal pleasure or recreation
Illustrative court case
In one court case, partners operated a farm that bought, sold, bred and raced Standardbred horses. It didn’t qualify as an activity engaged in for profit, according to a U.S. Appeals Court. The court noted that the partnership had a substantial loss history and paid for personal expenses. Also, the taxpayers kept inaccurate records, had no business plan, earned significant income from other sources and derived personal pleasure from the activity. (Skolnick, CA 3, 3/8/23)
Contact your GT Reilly advisor for more details on whether a venture of yours may be affected by the hobby loss rules, and what you should do to avoid tax problems.
