Avoid the Hobby Loss Rules

We are living in the age of the “side hustle.” Talk to ten of your friends and colleagues, and chances are at least half of them are building a little something on the side. Side hustles can be incredible. They give you a way to outlet your passions and hopefully make a little money outside of your 9-to-5 j-o-b. However, if you don’t have a business plan, specifically a documented profit motive, your side hustle could quickly become classified a hobby by the IRS, and that doesn’t sound nearly as cool.

The Hobby Loss Rules are governed by Internal Revenue Code Section 183 and include what’s called a Safe Harbor test to determine if your business is really a hobby. It relies on how many years you report a profit versus a loss on your tax returns (Schedule C). In general, it is assumed if you have profit 3 out of 5 consecutive years, you are engaged in a for-profit activity and therefore not a hobby. If you have more years of losses, you have to prove you are involved in operations for profit, not just for fun. Don’t worry! Profit can still be fun! We are continuously amazed at what people do for a living. Amazing!

The IRS’s website has some excellent hobby loss rule resources as well, and explains how to deduct hobby expenses. Note that we said expenses and not necessarily losses. Yup! If you are deemed to have a hobby and not a business, you may still deduct the hobby expenses against the hobby revenue.

Back to the issue at hand… wanting to deduct your business losses… just like your father might have said, your actions are going to speak much louder than your words. Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit. In order to make this determination, you should consider the following factors which are detailed in IRC Section 1.183-2(b)–

1. The manner in which the taxpayer carries on the activity
2. The expertise of the taxpayer or his advisers
3. The time and effort expended by the taxpayer in carrying on the activity
4. The expectation that assets used in the activity may appreciate in value
5. The success of the taxpayer in carrying on other similar or dissimilar activities
6. The taxpayer’s history of income or losses with respect to the activity
7. The amount of occasional profits, if any, which are earned
8. The financial status of the taxpayer
9. The elements of personal pleasure or recreation.

Warning: this is not an all or nothing or weighted list. The Tax Court looks at the full picture and how each factor relates to the facts as a whole. For example, are you a concrete contractor waiting for the housing market to pick back up? Are you a tech start-up developing a new product that will take 5-7 years to bring to market.

Thankfully, there are a few Tax Court cases that give us some foundation to fall back on to ensure that while figuring out the whole “How to Make a Profit” thing, that we don’t get dumped into the Hobby Loss pit of misery instead of bonafide Business Loss (which is equally miserable but at least tax deductible).