That is a serious question for many individuals who are moonlighting from their “day job” with a sideline business. We have all heard the stories over the years of people deducting 20 straight years of losses on their horse farm business, but what about the guy who races stock cars or buys and sells rare coins?

To be honest, the business/hobby issue is rife with gray areas. However, the IRS has set forth nine criteria that you can use to determine whether they will consider your endeavor to have a profit motive (an essential element in order to deduct business losses). The IRS cautions that whether a profit motive exists will depend upon the circumstances of each case.

The nine factors are:

The manner in which the taxpayer carries on the activity.

Are you treating your endeavor like a legitimate business?  Generally, that means you will maintain a separate checking account, some type of accounting system and you will have registered your business with the various state and local authorities as a legitimate business.

The expertise of the taxpayer.

Is this a business in which you have some noted skill or expertise?  If not, you need to make certain that you are consulting and listening to the advice of people who do.

The time and effort spent by the taxpayer in the activity.

Obviously, the hobby/business issue generally only comes up when the business is being conducted as a sideline.  If you are devoting all of your time to the business, the IRS will likely have a difficult time proving that you don’t have a motive to earn profits.  However, sideline businesses are allowed and the more time you spend working in the business, the more it will help your case with the IRS.

The expectation that the assets used in the activity will appreciate in value.

There have been court cases which allowed business losses if the taxpayer could demonstrate that his or her assets used in the business (i.e. a horse farm) would appreciate significantly in value and eventually offset the losses.  This is a gray area and probably not one you would want to “hang your hat on” in a battle with the IRS.

The success of the taxpayer in other activities.

Even if you are continually losing money with your endeavor, the IRS may accept an indication of profit motive if you can prove that you have been previously successful in this type of business.

The history of income or losses.

This is the issue which will generally trigger a question by the IRS.  Your willingness to sustain continued losses in a business may generate skepticism by the IRS that your endeavor is more for fun than profit.  However, if those losses are explainable and beyond your control (theft, fire, act of God, etc), you will have a better case.

The amount of any earned profits.

We have had clients over the years that wanted to skip taking deductions for their endeavor in order to occasionally show a small profit.  Their reasoning is that this would “trick” the IRS into thinking their hobby was a legitimate business.  Unfortunately for most of us, the IRS isn’t a “ship of fools.”  Showing small profits on occasion may not help your case much if they are dwarfed by the losses taken in other years.

The financial status of the taxpayer.

Sometimes, its actually beneficial to be poor!  If you are in a low tax bracket, the IRS will be more easily convinced that your endeavor has a profit motive since tax write-offs would not be a primary concern for you.  However, individuals in a high tax bracket won’t receive the same consideration for obvious reasons.

Elements of personal pleasure or recreation.

Does your endeavor contain elements of fun or personal leisure?  In other words, if you’re racing cars or running a petting zoo for children, you may have a problem convincing the IRS that your continuing losses are business related.  However, just because you enjoy what you’re doing also does NOT mean that you do not have a profit motive.  Does this make sense?

Quite obviously, each of the issues the IRS will examine above are clouded in shades of gray. Sometimes it simply helps to have someone take an objective look at what you’re doing and play the devil’s advocate with these issues before the IRS does. If you have concern that you may be at risk in this area, please give us a call to discuss your situation.