The IRS has rules that limit the deductibility of expenses and losses from a hobby or activity not engaged in for profit. If the IRS determines that an activity is not profit-driven, deductions from the activity are limited to the amount of income the activity generates. Losses from such activities cannot be used to offset other income, such as salary or investments.
In being able to deduct a net loss from a business – whether it is a business that normally has ups and downs or one in which the unexpected might occur – you must be prepared to show that an activity that generates deductions is a business from which you intend to profit. It is not necessary that the activity actually earns a profit, so long as a profit is one of the motives for participating in the activity.
The IRS assumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year, or at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses. Otherwise, the IRS applies non-exclusive tests and factors to the surrounding facts to judge whether activities are more like a business with a profit motive, or are for personal satisfaction. Under IRS rules and judicial precedent, the following nine factors are considered in determining whether an activity is engaged in for profit:
1. the manner in which the taxpayer carries on the activity;
2. the expertise or experience of the taxpayer’s advisors;
3. the time and effort the taxpayer expends on the activity;
4. the expectation that the assets used in the activity may appreciate in value;
5. the success of the taxpayer in carrying on other similar or dissimilar activities;
6. the taxpayer’s history of losses from the activity;
7. the amount of occasional profits earned from the activity;
8. the taxpayer’s financial status; and
9. the elements of personal pleasure or recreation derived from the activity.
These factors are not exclusive in determining a profit motive, and if the circumstances warrant, are not given any weight.
To make sure you are properly claiming all of the deductions available to you, and to strengthen your position in the event of an IRS audit, it is important to consider all the facts and circumstances surrounding activities the IRS is likely to challenge.
If you would like assistance in documenting the for-profit characteristics of your activity, please call our office at your earliest convenience to arrange an appointment.