Have you ever considered turning a hobby into an income-producing activity? Starting a second business around something you love to do can provide outstanding tax benefits. But, before diving into a new enterprise, individuals should understand IRS hobby loss rules. These rules provide strict guidelines about what you can and cannot deduct. As such, we’ll use this article to explain the IRS hobby loss rules to help you get some tax deductions for doing what you love.
Specifically, we’ll cover the following topics:
- How Can a Second Business Lower My Taxes?
- What is the Hobby Loss Rule?
- IRS Hobby Criteria: Explained
- How to Avoid a Hobby Designation for Your New Business
- Other High-Earner Tax Strategies
How Can a Second Business Lower My Taxes?
As a business owner, you’ve seen first-hand the tax benefits of writing off business expenses. If organized correctly, you can reap those same tax benefits by starting a second business. More precisely, if you have something you love doing, you can turn it into a business. In that way, you A) earn revenue doing something you’re passionate about, and B) lower your taxes by writing off the associated business expenses.
However, before diving headfirst into a second business, it’s important to understand how the IRS treats hobbies and businesses differently. According to IRS guidance, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit. And, as a business, you are allowed to deduct the ordinary and necessary expenses incurred in that activity. If your expenses exceed revenue, you recognize a taxable loss and can use that loss to offset other income.
On the other hand, the IRS views hobbies as activities not conducted in pursuit of profit. According to IRS publications: people engage in a hobby for sport or recreation, not to make a profit. This difference has significant tax implications. The IRS states that: if an activity is not for profit, losses from that activity may not be used to offset other income. That is, you cannot use losses from a hobby to reduce your other taxable income.
For example, say in your free time you make wood carvings and recently decided to start selling them. In your first year selling these carvings, you take a loss of $5,000. If the IRS classifies you as a business, you can use that $5,000 in losses to offset other income (e.g. salaries, investments, etc.). But, if the IRS deems your activity a hobby, you cannot use those losses to offset other income. Formerly, with a hobby, your expenses could only offset the revenue associated with that activity. After the passage of the 2017 Tax Cuts and Jobs Act, taxpayers cannot deduct any expenses associated with a hobby. But, they still need to report income, making these rule changes doubly painful.
For people considering turning a passion into a second business, it’s critical that you understand these rules to avoid having the IRS label your activity a hobby.
What is the IRS Hobby Loss Rule?
While the IRS outlines detailed hobby criteria (which we’ll discuss below), the most critical factor involves the profitability of your activity. Known as the hobby loss rule, the IRS states: An activity is presumed for profit if it makes a profit in 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).
Continuing the above wood carving example, assume your activity had the following operating results over the last five years:
- Year 1: $1,000 loss
- Y2: $1,000 loss
- Y3: $1,000 profit
- Y4: $2,000 profit
- Y5: $3,000 profit
In this scenario, you would pass the IRS hobby loss rule. Due to the fact that your activity earned a profit in three of the past five years, it would qualify as a for-profit business. As a result, the losses from the first two years of operations could offset your other taxable income.
Now, assume that for the same activity, you experienced the following results:
- Year 1: $1,000 loss
- Y2: $1,000 loss
- Y3: $1,000 loss
- Y4: $2,000 profit
- Y5: $3,000 profit
In this situation, your wood carving activity would fail the hobby loss test. Due to the fact that you didn’t make a profit in three of the past five years, the IRS would classify your activity as a hobby, not a business. That means that you could not use the losses incurred in the first three years to offset your other income. In the case of an IRS audit, those claimed losses would be disallowed, and you’d owe the associated back taxes.
IRS Hobby Criteria: Explained
In addition to the hobby loss rule, the IRS outlines nine criteria to determine whether your activity qualifies as a hobby or business. The IRS takes the following into consideration: Take into account all facts and circumstances with respect to the activity […]. In reviewing a case, you must generally consider these [nine] 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.
- You have personal motives in carrying on the activity.
- The time and effort you put into the activity indicate you intend to make it profitable.
- You depend on income from the activity for your livelihood.
- Your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
- You or your advisors have the knowledge needed to carry on the activity as a successful business.
- You were successful in making a profit in similar activities in the past.
- The activity makes a profit in some years and how much profit it makes.
- You can expect to make a future profit from the appreciation of the assets used in the activity.
If a question exists about the proper designation of your activity the IRS will closely examine its operations in the context of the above nine criteria.
How to Avoid a Hobby Designation for Your New Business
As the above should make clear, you do not want the IRS to label your activity as a hobby. Operating a second business, you can deduct ordinary and necessary expenses, and losses can offset other income. But, with a hobby, you can’t currently deduct any expenses. Here’s how we recommend avoiding a hobby designation for your new business:
Recommendation 1: Make Money
Without question, the surest way to avoid the hobby designation is making money. If your new business passes the above hobby loss rule, the IRS will accept your business classification. Conversely, failing to make a profit is a sure-fire way to receive the dreaded hobby designation, negating all of your previous deductions.
Recommendation 2: Establish a Separate Legal Entity
In the above hobby criteria, the IRS emphasizes the importance of operating your activity in a businesslike manner to avoid hobby designation. One way you can do this is by establishing a separate legal entity under which you operate your business. From a tax perspective, the IRS disregards single-member LLCs, instead of treating them as sole proprietorships. But, in a facts and circumstances evaluation of activity, forming a separate LLC certainly supports the idea of operating in a businesslike manner.
Recommendation 3: Keep Separate Accounting Records
Maintaining separate accounting records also demonstrates a businesslike manner. If you want to avoid the hobby designation, you should first open a separate, business bank account to avoid commingling personal and business funds. In doing so, you should also maintain separate accounting records, closely detailing the revenues and expenses of your business. In the case of an IRS audit, these separate books will further support a business – not hobby – designation for your activity.
Other High-Earner Tax Strategies
Forming a second business to take deductions for doing what you love is just one way to reduce your taxable income. At Shared Economy Tax, we live and breathe tax-saving strategies for high earners. If you’d like to discuss options to lower your tax bill, contact us to set up a tax planning strategy session!