Turning a passion into a side business is one of the more appealing tax planning moves available to high earners. When structured correctly, a legitimate second business lets you deduct ordinary and necessary expenses, offset losses against other income, and reduce your overall tax bill while doing something you actually enjoy. However, it could also cause major issues if you run astray of the IRS’s hobby loss rules.
Before you start writing off your woodworking tools, photography equipment, or dog breeding expenses, you need to understand how IRC Section 183, the hobby loss rule, works and how to make sure your activity doesn’t get reclassified as a hobby.
The stakes are higher now than they’ve ever been. The One Big Beautiful Bill Act, signed into law in 2025, made the prohibition on hobby expense deductions permanent. Under prior law, the suspension was set to expire after 2025. It no longer will. That means getting the business vs. hobby distinction right is not just a planning consideration. It’s a permanent feature of the tax code.
How Can a Second Business Lower My Taxes?
As a business owner or self-employed professional, you already understand the value of deducting ordinary and necessary business expenses. A legitimately structured second business extends those same benefits to a new activity.
The key word is legitimately. According to IRS guidance, an activity qualifies as a business if it is carried on with a reasonable expectation of earning a profit. Meet that standard and you can deduct related expenses on Schedule C, and if those expenses exceed revenue, the resulting loss can offset other taxable income, including wages, investment gains, and self-employment income from other businesses.
Fail to meet that standard and the IRS labels your activity a hobby, and the consequences are severe.
What Happens When the IRS Calls It a Hobby?
Before 2018, hobby expenses could at least be deducted up to the amount of hobby income as miscellaneous itemized deductions, subject to a 2 percent AGI floor. That limited deduction disappeared under the Tax Cuts and Jobs Act, which suspended miscellaneous itemized deductions from 2018 through 2025. The OBBBA made that suspension permanent.
Here’s what that means in practice: if the IRS classifies your activity as a hobby, you must still report every dollar of income it generates. You just can’t deduct a single dollar of the expenses you incurred earning it. Not the supplies, not the equipment, not the travel. Nothing.
Starting in 2026, under a new OBBBA provision, hobby expenses can be deducted up to 90 percent of hobby income. That sounds like a partial improvement, but it still means 10 percent of hobby income is always taxable even when your expenses exceed your revenue, and it still leaves you unable to use hobby losses to offset any other income.
The math is painful either way. The only real solution is making sure your activity qualifies as a business, not a hobby.
The Hobby Loss Rule: The IRS’s Primary Test
The most critical factor in the hobby vs. business determination is profitability. Under the hobby loss rule, an activity is presumed to be a for-profit business if it generates a profit in at least three of the last five consecutive tax years. For activities involving the breeding, training, showing, or racing of horses, the threshold is two of the last seven years.
Meeting this standard creates a presumption of profit motive, which the IRS must then overcome to reclassify your activity as a hobby.
Here’s what the difference looks like in practice. Say you start a side business selling handmade furniture and your results over five years look like this:
- Year 1: $2,000 loss
- Year 2: $1,500 loss
- Year 3: $1,000 profit
- Year 4: $3,000 profit
- Year 5: $4,000 profit
Three profitable years out of five. You pass the test. The losses from years one and two are defensible as business losses.
Now shift the numbers slightly:
- Year 1: $2,000 loss
- Year 2: $1,500 loss
- Year 3: $2,000 loss
- Year 4: $3,000 profit
- Year 5: $4,000 profit
Only two profitable years out of five. You fail the test. The IRS can reclassify your activity as a hobby, disallow the losses from years one through three, and assess back taxes plus interest and penalties on any returns where you claimed those losses.
One useful but underutilized tool: IRS Form 5213 allows a new business owner to request a deferral of the IRS’s determination while the activity is still in its early years. Filing Form 5213 within three years of starting the activity or within 60 days of receiving an IRS notice signals to the agency that you’re operating with a genuine profit motive and need time to establish the track record.
The IRS’s Nine-Factor Test
Passing the profit presumption provides a safe harbor, but the IRS can still challenge your business status based on a broader facts and circumstances analysis. The agency uses nine factors to evaluate whether an activity is genuinely for profit. No single factor is decisive. The IRS weighs all of them together.
1. Businesslike manner. Does the activity have its own books, records, bank accounts, and operating procedures? Commingling personal and business finances is a red flag. Maintaining separate accounting records is a basic signal of legitimate business intent.
2. Expertise. Have you, or have the people you’ve consulted, developed real expertise in the field? The IRS looks favorably on activities where the taxpayer has taken meaningful steps to develop competence, through courses, mentors, industry associations, or prior experience in related areas.
3. Time and effort. How much time do you spend on the activity? A consistent, substantive time commitment suggests genuine pursuit of profit. Occasional weekend participation does not.
4. Dependence on income. Do you rely on this activity for your livelihood, or is it supplemental to a comfortable primary income? Dependence on the income supports a profit motive argument.
5. Losses and their nature. Persistent losses aren’t automatically disqualifying. The IRS distinguishes between losses that reflect startup challenges or circumstances beyond the taxpayer’s control versus losses that simply indicate a lack of serious business intent.
6. History of profit. Have you made money doing similar things in the past? A track record of profitability in related ventures supports the argument that this activity is being pursued as a business.
7. Profit in some years. Even intermittent profitability supports the business designation. A complete absence of any profitable years over a long period is a significant warning sign.
8. Appreciation potential. Is there reason to expect the assets used in the activity to appreciate in value, even if the activity itself isn’t currently profitable? This applies most clearly to real estate and livestock but can be relevant in other contexts.
9. Personal enjoyment. This is the most intuitive factor. The more the activity resembles a personal passion or recreational pursuit, the more scrutiny it attracts. Enjoying your work doesn’t disqualify you, but it does mean the other factors need to be especially well-documented.
How to Avoid the Hobby Designation
Understanding the criteria is the first step. Actively building a record that supports the business designation is the second.
Make Money
The most straightforward protection is profitability. If your activity clears the three-out-of-five-year threshold, the IRS is generally not going to pick a fight over hobby classification. Set revenue goals, measure performance against them, and document your efforts to improve results when the business falls short.
Establish a Separate Legal Entity
Forming a separate legal entity, whether an LLC, S corporation, or other structure, demonstrates that you’re operating in a businesslike manner. While a single-member LLC is disregarded for federal income tax purposes, it still supports the factual argument that your activity is a business, not a pastime. It also provides liability protection and creates a cleaner separation between your personal finances and the business.
Deciding between an LLC and other structures depends on your income level, the nature of the activity, and your broader tax situation. A conversation with a tax professional before you form the entity can save a lot of corrective work later.
Keep Separate Books and Records
Open a dedicated business bank account and, ideally, a separate business credit card. Run all business income and expenses through those accounts. Maintain a profit and loss statement for the activity throughout the year, not just at tax time. Document your business plan, pricing strategy, and any adjustments you’ve made in response to losses or underperformance.
In an audit, these records are your primary line of defense. The IRS is looking for evidence that you’re running something, not just spending money on a hobby and calling it a business.
Document Your Profit Motive Actively
Beyond records, build a paper trail of intent. Keep notes from meetings with advisors. Save correspondence about industry trends or competitive analysis. Document decisions you made to improve profitability. If you incurred a loss in a given year, write a brief memo explaining why and what you changed as a result.
The IRS’s nine-factor test is ultimately a story about whether you’re genuinely trying to make money. The more clearly you can tell that story through contemporaneous documentation, the stronger your position.
What If Your Activity Isn’t Profitable Yet?
New businesses rarely are. The IRS understands this, which is why the profit presumption is based on a five-year window rather than requiring immediate profitability. The key is demonstrating from day one that you are operating with a genuine intent to earn a profit, even if the results haven’t materialized yet.
If you’re in the early years of a side business that’s generating losses you want to deduct, consider consulting a tax professional now rather than after the IRS sends a notice. Proactively structuring the activity to satisfy the nine-factor test is far easier than defending a reclassification after the fact.
Other Tax Strategies for High Earners
The hobby loss rules are one piece of a broader tax planning picture for high earners and self-employed professionals. If reducing your overall tax liability is a priority, there are a range of strategies worth exploring in parallel, from maximizing self-employed deductions and leveraging the Qualified Business Income deduction to capital gains deferral strategies and cost segregation for real estate investments.
The right combination depends on your income sources, entity structure, and long-term goals. Schedule a free one-on-one strategy session with the Shared Economy Tax team to discuss which approaches make the most sense for your situation.
