Requirements for Claiming Hobby-Related Tax Deductions

Are you a collector and occasional seller of antiques, rare coins, or classic cars? If so, you may be able to claim hobby-related tax deductions – but only if specific conditions exist.

The IRS considers a hobby to be any activity that’s not intended to make a profit, even if you do occasionally make money off it. In order to claim a tax deduction for hobby-related losses, a taxpayer must show that that the losses amounted to more than 2 percent of his or her annual adjusted gross income. But a taxpayer may deduct only those hobby-related losses that are less than or equal to one’s profits from that hobby – if no profit was earned, no deductions can be claimed.

Tax laws differentiating hobby-loss deductions and business-related deductions are intended to prevent fraud. For example, businesses generally are entitled to deduct all expenses from their income, so a hobbyist might be tempted to allege that a recreational activity is a business. But that behavior may trigger an IRS audit, and when a business fails to make a profit in at least three out of the previous five years, the IRS may reclassify it as a hobby.

How the IRS Defines Business-for-Profit

The taxpayer bears the burden of proving that a profit objective exists to avoid being classified as a hobby. The IRS considers nine factors when making this determination. Those factors that commonly indicate an activity is a business include:

  • The taxpayer has earned a profit from the activity in three of the previous five years, (or two of the previous seven years, if the activity is breeding, showing, training, or racing horses).
  • The effort invested in the activity indicates an intention to make a profit.
  • The taxpayer has changed operational methods to improve profitability.
  • Appreciation of assets used in the activity is anticipated to produce future profit.
  • Claimed losses are a result of uncontrollable circumstances, or are attributed to the costs of start-up.
  • The taxpayer depends on income from the activity.

When deciding whether to pursue a hobby as a business-for-profit, working with a business attorney can help an entrepreneur provide sufficient evidence that an endeavor is actually a business.

Proving the Existence of a Business

Even when you’re able to show the IRS that you meet the nine-factor test of operating a business, you may need additional evidence to support that claim.

Records such as organizational mission statements, bylaws, tax ID numbers, and articles of incorporation may be presented as evidence that a previous hobby is now a business. Seeking professional guidance from tax and legal professionals, business advisors, or help from investors would also be a strong indicator that a business is legitimate.

Getting Through the Start-up Stage

When a business is first established, it may take a few years to begin making a profit. For budding entrepreneurs, three years of consecutive losses likely will trigger an IRS review and may result in reclassification of a business as a hobby.

Business owners that anticipate operating at a loss in year three may file IRS Form 5213, “Election to Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit.” Filing the form can give business owners more time to turn a profit and maintain their status as a legitimate business.

Lusk Law, LLC, specializes in assisting small businesses at start-up and throughout their existence, helping to avoid litigation when possible, and actively representing our clients in court when litigation is necessary. Our experienced attorneys have provided legal counsel and representation to entrepreneurs in Frederick County, Howard County, Baltimore County, Baltimore City, Carroll County, Washington County, and Anne Arundel County, and throughout Maryland, Virginia and the District of Columbia. Please call us at 443-535-9715 or fill out our contact form if you have any questions about this topic.

What are the Types of Business Structures?

Before you launch a small business, two questions you should consider are: What are the types of business structures, and which one best fits my needs? The main types…