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Protect Your Business Deductions – Avoid the Hobby Loss Rules

Avoid Hobby Loss Treatment and Protect Your Business DeductionsThe hobby loss rules apply to small business owners and farmers.

Hobby loss treatment disallows losses in your business or farm, and is an often misunderstood area of tax law.  It is important that all small business owners and farmers understand these regulations and the potential effects on their taxes.

This article addresses the basics:

  1. What are “hobby” losses?
  2. What happens if my business/farm is treated as a hobby?
  3. What can I do to avoid having my business/farm treated as a hobby?

What Are Hobby Losses?

In short, the hobby loss rules are designed to keep people from starting a business whose real motive is fun, not making a profit.

For example, this might include car buffs trying to write off their personal car show/drag racing hobby as a “business”, or someone starting a small farm but never really selling much of anything and just claiming a bunch of expenses.

Those are simplistic examples.

What really determines whether the IRS can investigate your small business or farm for a profit motive is if you show losses in 3 out of 5 consecutive years (2 out of 7 for horse activities)

However, failing to show a profit for 3 of 5 years doesn’t mean straight away that you’re going to fall into the hobby category, it just means that they CAN look into it further once you’ve satisfied that condition.

If you fail to show a profit for 3 out of 5 years and are selected for audit, there are 9 guideline factors that will be applied to determine whether your business or farm is a legitimate business or a hobby, which we’ll address in a bit.

What Happens if My Business/Farm is Treated as a Hobby?

If your business or farm is determined to be a hobby, you will only be able to deduct expenses to the extent of your activity’s income.  Any excess expenses will be disallowed.

This means that you will lose the benefit of any depreciation, fuel, or other expense that exceeds the income from your business or farm, no matter how legitimate they are.

Therefore, it is important to make sure to do a good job of managing your business/farm and what is reported on your income tax returns in order to stay out of the “3 in 5” category and reduce your risk of audit.

New businesses and farms are especially at risk and you should take special care if this applies to you.

What Can I Do to Avoid Hobby Loss Treatment?

In short, you should conduct the activity in a businesslike manner.  

To determine whether your business or farm is actually a business or not, the IRS will apply 9 guidelines to your activity:

  1. Is the activity carried on in a businesslike manner?
  2. What is the expertise of the owner or his or her advisors?
  3. How much time and effort are being spent in the activity?
  4. Are the assets expected to increase in value?
  5. Has the owner operated similar activities for a profit before?
  6. What is really going on with this activity (i.e. is a new business, was there a drought, flood, etc.)?
  7. Has the owner made any money in the activity?
  8. Does the owner have substantial income from other sources (i.e. a “regular” job)?
  9. Is the owner having fun?
The IRS is required to take into account the facts and circumstances surrounding your activity.  That’s why it’s so important that you keep good records.  Activities that have the potential to make a profit, can reasonably be expected to make a profit, or that have made profit in the past will be more likely to avoid hobby loss treatment.
Following are some suggestions can help you avoid hobby loss treatment:
  • Keep thorough and “businesslike” records and books
  • Use a separate business checking account and credit cards
  • Keep personal expenses out of the business
  • Record business and personal use of assets in a log book
  • See what other similar (and successful) businesses are doing and implement those practices into your business
  • Consult with professional advisors (i.e. accountants, attorneys, etc.)
  • Get the insurance, proper licenses, etc. normally needed for your business
  • Have a separate telephone number for your business
  • Keep good records of any circumstances out of your control (e.g. floods, droughts, etc. for farmers)
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