What happens when the IRS considers your business or farm to be a hobby?
The IRS commonly examines farms and businesses to see if they can be ruled as a hobby.
If the IRS rules that your business is a hobby, the consequences can be significant.
The consequences are even worse as a result of the 2018 tax changes. Before the 2018 tax changes, hobby income was reported on the 1040 as other income and the expenses could be deducted by itemizing on the Schedule A. As a result of the tax changes the expenses are no longer deductible.
As an example of the effect of being ruled a hobby, suppose that you had previous years of losses and the IRS ruled it a hobby. In the current year, you had income of $20,000 and expenses of $19,000. If it were a business, you would pay taxes on the profit of $1,000. However, if your business is ruled a hobby, you would be paying taxes on $20,000, rather than $1,000.
If you have losses, you should be aware of the “hobby farming rules” of Internal Revenue Code Section 183, which state that the IRS won’t allow you to claim any loss incurred through hobby activities as an offset against other taxable income.
For the benefit of farmers, a “two out of five years” tax rule was enacted in 1969 and revised in 1976. The regulation allows a farmer or part-time entrepreneur to elect in advance a five-year period of time in which to show the ability to make a profit.
According to the IRS, when making the distinction between a hobby or business activity, you need to take into account all facts and circumstances with respect to the activity. A hobby activity is done mainly for recreation or pleasure. No one factor alone is decisive. You must generally consider these factors in determining whether an activity is a business engaged in making a profit:
Whether you carry on the activity in a businesslike manner and maintain complete and accurate books and records.
Whether the time and effort you put into the activity indicate you intend to make it profitable
Whether you depend on income from the activity for your livelihood.
Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
Whether you change methods of operation in an attempt to improve profitability.
Whether you or your advisors have the knowledge needed to carry on the activity as a successful business.
Whether you were successful in making a profit in similar activities in the past.
Whether the activity makes a profit in some years and how much profit it makes.
Whether you can expect to make a future profit from the appreciation of the assets used in the activity.
David Zubler is a tax accountant and Enrolled Agent representing clients before the IRS with over 25 years of tax experience. He is the author of four tax books and is the founder and president of Your Tax Care. The company provides business and tax education to the public at its website, YourTaxCare.com. David can also be contacted by email at firstname.lastname@example.org