*Editor's Note: This blog has been updated as of August 16, 2022 for accuracy and comprehensiveness.

If the IRS thinks your side-business is a hobby rather than a business, you could owe Uncle Sam more than you think. So, how do you decide if your side venture is a for-profit endeavor? The IRS has a few determining factors that they look for....

Business vs. hobby

You must consider all facts and circumstances when deciding whether you are in fact carrying on a legitimate business or simply trying to create losses and utilize them to offset other income. Section 183 of the tax code, “The Hobby Loss Rule” was developed to help you determine this.

Are you engaged in your activity for profit?

The IRS has a list of 9 factors to help you determine whether your activity is a business or hobby. Keep in mind that no single factor defines this, but rather, all facts and circumstances must be considered.

The IRS is mostly looking for proof that you are in it to make a profit. The more of these factors that you can answer “yes” to, the more likely your activity will be considered a business.

1. Does the time and effort put into the activity indicate an intention to make a profit?
2. Do you carry on the activity in a businesslike manner? (i.e. maintaining separate personal and business bank accounts, keeping records and books etc.)
3. Do you have the expertise needed to carry on the activity as a successful business? The IRS wants to be sure you have the education and/or advice from experts on how to successfully run a business.
4. Does the activity make a profit in some years? Typically, if you have not turned a profit in a minimum of three of the prior five years (the ‘3 out of 5 rule’), the IRS will presume your business to be a hobby. There is one exception to this presumption: if you are engaged in activities that consist primarily of breeding, showing, training or racing horses—in this case you must make profit in at least two of the last seven years to be considered a business. It should be noted that this presumption can still be rebutted by the taxpayer if they can show enough other facts that show a clear intention of ultimately making a profit
5. Have you made a profit in similar activities in prior years?
6. Do you expect to profit in the future from the appreciation of assets used in the activity?
7. Do you depend on the income generated from the activity?
8. Did losses occur? When? The IRS wants to know how your losses were incurred—your hobby could be considered a business if losses were incurred in the startup phase, or as a result of something outside of your control.
9. Have you sought to improve profitability by changing your operation methods?

So, what happens if my hobby is considered a business?

If, after considering the nine factors above, you determine that your hobby is indeed a business, you can claim deductions for the losses incurred in the operation of this “side venture”.

Does IRC 183 allow any hobby deductions?

If your activity is not carried on for profit, there are deductions available, however they cannot exceed the gross receipts for the activity. Hobby activity deductions are claimed as itemized deductions on Form 1040, Schedule A. They have to be taken in the following order, however:

1. Certain personal expense deductions, such as home mortgage interest and taxes (can be taken in full.)
2. Advertising, insurance premiums, wages, and other deductions that do not result in an adjustment to a property’s basis can be taken after #1, but only to the extent that gross income for the activity exceeds the deductions from #1.
3. Deductions that adjust a property’s basis, like depreciation and amortization, can be taken last, but only to the extent that the activity’s gross income is greater than the deductions taken in the above two categories.

Questions on your hobby’s classification? Contact any member of our Tax Services Team.