Running a business involves carefully tracking income and expenses, paying taxes, and following all applicable regulations. The IRS distinguishes businesses from hobbies based on whether the activity is carried out to make a profit. If the IRS classifies a venture as a hobby rather than a business, it can have significant financial implications.
What are the IRS requirements for a business?
The IRS uses several criteria to determine whether an activity qualifies as a business or a hobby:
- Whether the activity is carried out in a businesslike manner
- Whether the taxpayer maintains complete and accurate books and records
- Whether the activity actually generates a profit
- Whether the taxpayer depends on income from the activity for their livelihood
- Whether the taxpayer changes methods of operation to improve profitability
- Whether the taxpayer or their advisors have the knowledge needed to carry out the activity as a business
- Whether the taxpayer devotes substantial time and effort to carrying out the activity
- Whether the taxpayer withdrew from another occupation to devote time to the activity
- Whether the activity has produced profits in some years and how much profit it has generated
- Whether the profits are expected to increase in future years
No single factor determines whether the IRS will classify an activity as a hobby or business. The agency looks at all the circumstances to make a determination.
What happens if the IRS declares a business is actually a hobby?
If the IRS concludes that a purported business is actually just a hobby, there can be significant financial consequences:
- Business expenses become miscellaneous itemized deductions. As a hobby, the expenses deducted for the activity are considered miscellaneous itemized deductions. This means they are only deductible to the extent they exceed 2% of the taxpayer’s adjusted gross income. Many hobby expenses end up nondeductible.
- Schedule C business deductions are disallowed. Expenses deducted on Schedule C for a business are fully deductible. But hobby expenses deducted on Schedule C will be disallowed by the IRS and taxes reassessed.
- Business use of the home deductions rejected. A business can deduct a portion of household expenses for the space used, but a hobby cannot claim this deduction.
- Self-employment tax payments rescinded. Someone operating a business has to pay into Social Security and Medicare through self-employment tax. These tax payments would be rescinded if the activity is a hobby, not a business.
- The hobby is subject to the hobby loss rules. The IRS limits deductions for hobbies to the amount of hobby income each year. Losses can only be deducted up to $50,000 ($25,000 for a married individual filing separately) when figuring AGI. Any additional losses must be carried over to future years.
Converting from a business to a hobby is generally undesirable, since it limits the ability to deduct expenses and results in more taxable income.
What causes the IRS to reclassify a business as a hobby?
There are several red flags that may trigger the IRS to take a closer look at a purported business and potentially deem it a hobby:
- Failing to report a profit for multiple years in a row
- Having significant expenses despite little income from the activity
- Showing losses despite no concrete plan to improve profitability
- Keeping poor records and not operating in a businesslike manner
- Having expenses that seem more related to a hobby than a business
- Not relying on activity income for regular living expenses
- Lacking knowledge or experience related to the industry
- Devote little time and effort to the activity
Essentially failing to operate like a real business in any respect – expenses, records, expertise, time, income, etc. – raises suspicion that the activity is not truly commercial.
How can you avoid an IRS hobby designation?
To help demonstrate an activity is truly a business, it helps to:
- Have a business plan showing how you intend to make a profit
- Spend significant time working in the business
- Take steps to improve profitability each year
- Have licenses, registrations, training, and advisers appropriate for the business
- Advertise and market the business
- Keep detailed records of income and expenses
- Follow all legal requirements and regulations for the industry
- Rely on the business for significant income each year
Showing that the activity is carried out regularly, systematically, and in a commercial manner helps demonstrate it is a business, not merely a hobby.
What if the IRS decides to audit your business tax return?
If the IRS selects your business tax return for an audit, they will closely examine your records to determine whether your activity should truly be considered a business. Steps to take if facing a hobby vs. business audit include:
- Gather records that show your business efforts – advertising, licenses, training, dedicated workspace, etc.
- Highlight specific steps you have taken each year to try and make the business profitable
- Note any special circumstances that help explain business losses
- If the business is part-time, keep records showing substantial time devoted to it
- Consult a tax professional who can help you make the case it is a business
- Emphasize that you rely on the business income for your livelihood
- Have cohesive reasons explaining all business expenses
With good records and tax help, you may be able to successfully defend your business status to the IRS during an audit.
Can you appeal an IRS hobby designation?
If the IRS concludes your activity is a hobby, you do have appeal rights:
- You can request a reconsideration from the IRS office that examined your return. Provide any additional documentation requested or make your case again in writing.
- You may also take your case to the IRS Appeals Office. They provide an independent review of the situation.
- Some taxpayers opt to go straight to tax court to resolve a hobby designation. This involves filing a petition within 90 days of the IRS determination.
- It’s possible to appeal even further to a U.S. District Court or the U.S. Court of Federal Claims if you disagree with the tax court ruling.
Having credible evidence to substantiate your efforts to operate as a business improves your chances on appeal. But professional tax guidance is highly recommended whenever disputing an IRS decision.
Are there penalties if your business is deemed a hobby?
Beyond losing deductions and owing back taxes and self-employment tax, other potential penalties may apply if your business is reclassified as a hobby:
- Accuracy penalties – These equal 20% of the underpayment amount. The IRS may impose them if it finds you were negligent or substantially understated income.
- Fraud penalties – Much harsher 75% civil fraud penalties apply if the IRS determines you intentionally tried to evade taxes.
- Failure to file penalty – If the IRS changes cause you to miss a filing deadline, penalties can apply for failure to file.
- Failure to pay penalty – Any taxes owed after a hobby reclassification may accrue failure to pay penalties if not resolved promptly.
Just having a business deemed a hobby does not automatically mean these penalties apply. But if the IRS believes you were deceptive or irresponsible, you could face such penalties.
Can you operate a business that consistently loses money?
It is possible to operate a legitimate business that loses money for multiple years. But doing so greatly increases audit risk and the chances of the IRS deeming it a hobby. Steps that can help justify consistent losses include:
- Having a clearly defined strategy for eventually becoming profitable
- Changing your operating methods to improve results
- Spending considerable time actively involved in the business
- Relying on the business as your primary livelihood
- Having losses occur due to circumstances beyond your control
- Making progress toward breaking even over time
Without evidence that you are sincerely working to make the business profitable, ongoing losses will appear to be more aligned with a hobby.
Should you continue operating a business if the IRS calls it a hobby?
If the IRS deems your activity a hobby rather than a business, you can certainly continue engaging in it. But you will need to resume filing taxes according to the hobby rules. Options include:
- Take substantial new steps to increase the profit motivation and commercial nature of the activity.
- Accept hobby status temporarily while rebuilding your case as a business.
- Continue as a hobby but cap losses each year to the IRS limit.
- Use the hobby as a side activity rather than primary livelihood.
- Phase out the hobby as circumstances permit.
Making significant changes and enhancements to show a profit motive often gives the best chance of having the activity reconsidered as a business once again.
Can the IRS reverse a hobby determination?
If an activity the IRS previously deemed a hobby takes major new steps to operate as a for-profit business, it may be possible to get the determination reversed. Strategies include:
- Update your operating model, products/services based on thorough market research
- Create a business plan focused on achieving profitability
- Consult with experts and advisors in the industry for guidance
- Invest in professional development, certifications, licensing for you and any staff
- Commit to spending substantially more time operating the business
- Advertise and connect with customers outside your personal circle
- Upgrade tools, equipment, facilities to enhance productivity
- Improve recordkeeping and business processes
- Generate outside funding or financing to support operations
The goal is demonstrating to the IRS that the nature and scope of the activity has materially changed in a commercial direction. With time and effort, it may be possible to eventually qualify again as a business rather than a hobby. But be sure to maintain thorough documentation of all your efforts.
Conclusion
Having the IRS reclassify a purported business as a hobby can significantly limit tax deductions and cause back taxes and penalties. By operating in a truly commercial manner with good records, it is possible to avoid the hobby issue as much as possible. And with effort, a hobby ruling can potentially be reversed if major profit-focused changes are made. But compliance is essential, and anyone facing a hobby determination should consult a tax professional to consider their options. With the right response, it may be possible to resolve the situation favorably.
