What Is the Hobby Loss Rule?
If your business goes too many years without making a profit, it can be classified as a hobby. When it becomes a hobby, you can no longer claim losses as business deductions.
In order to determine if you are running a business or a growing hobby, the Internal Revenue Service (IRS) looks at the following qualifications:
- Do you put in the time to turn a profit?
- Have you made a profit in the past?
- Do you have the necessary knowledge to succeed in your field?
- Do you depend on the income from this activity?
- Were your losses beyond your control?
If your business doesn’t turn a profit for 3 out of 5 years (except in specific industries, like horse racing) then it is classified as a hobby and you can no longer claim tax deductions against other revenue.
If you want to reverse the IRS’s decision about your business, then you have to prove your intention was to make a profit. Keep extensive files showing where you spent your money and how it was imperative to your business.
If you try to claim your hobby as a business then it could trigger an IRS audit. Only claim deductions if you are actually running a business. For more clarification on what constitutes a business or a hobby, the IRS has put out a helpful guide you may want to read.
Hobby Loss Scenario
To better illustrate the impact of the hobby loss rule, I have a scenario that many of our clients can relate to.
Janet is the blogger and owner of a lifestyle blog. She’s been blogging for 5 years. Over those years she’s claimed her blog as a business on her taxes. The first 2 years she did not make a profit. The third and fourth years she did bring in some money from her blog. This year Janet is hoping to make a profit again so that her blog isn’t classified as a hobby.
Janet’s blogging expenses for her fifth year in business were:
- Website hosting
- Website domain
- WordPress theme
- Purchased ad space on other blogs
- Blogging conference tickets and travel expenses
- 3 online courses
- Photoshop subscription
Janet brought in money from the following avenues:
- Selling ad space on her blog
- Several sponsored campaigns
- Paid social media posts
Unfortunately, Janet’s expenses outweighed her income and she reported another loss. According to the hobby loss rule, her blog is now considered a hobby, not a business.
Janet still wants to run her blog like a business. She is going to try to prove that she ran her blog with the intent to make a profit. Janet will show that she intended to make a profit by attending a conference to increase her knowledge. She also kept strict records showing her business expenses. She can submit these to try and still claim her deductions.
The IRS will have to determine if Janet’s blog can still be considered a business, but her careful records will benefit her in making a case.
If you are an owner of a newly established business, keep track of your business plans, receipts, and records. While we all hope to start turning a profit after the first few years in business, life can be unpredictable. Having these records in place can help you make your case that your business is a legitimate business, and you deserve the benefits that come with it.
If you need help with your business taxes or finances, reach out to our team. We specialize in helping small business owners save time, money, and stress on their taxes and accounting.