Many activities incur substantial start-up costs and losses in the first few years of operations.  Owners of these activities should take appropriate steps to understand the factors taken into consideration when the Internal Revenue Service (IRS) investigates an activity as a business or a hobby.  If an individual, partnership, estate, trust, or an “S” Corporation engages in an activity that is not conducted as a for profit business, deductions are limited to the amount of the income from the activity.  This rule does not apply to “C” Corporations.

Regulation Section 1.183-2(b) includes considerations for determining whether an activity is a business or a hobby:

1.  The manner in which the taxpayer carries on the activity – Does the activity maintain complete and accurate books and records?  Does the activity operate similarly to other profitable activities of this type?  Would a change in operating methods improve profitability.

2.  The expertise of the taxpayer and his/her advisors – What is the level of business knowledge of the taxpayer in the activity’s area of operation?  Who is the taxpayer consulting?  Are they employing the knowledge attempting to improve the activity?

3.  The time and effort expended by the taxpayer in carrying on the activity – How much time is spent on the activity?  Does the activity have any substantial personal or recreational aspects?  Does the taxpayer take time away from another occupation to seek a profit in this activity?  The time stipulation is usually not counted against the taxpayer if they hire employees to carry out operations for the business. 

4.  Expectation that assets used in the activity may appreciate in value – Even if the activity does not produce positive income flow, if assets held by the activity are expected to appreciate so that an overall profit is made from a sale, the activity may be considered a business. 

5.  The success of the taxpayer in carrying on other similar or dissimilar activities -  Has the taxpayer been successful in the past in taking other unprofitable ventures and making them profitable? 

6.  The taxpayer’s history of income and losses with respect to the activity – What has been the performance of the activity since inception? 

7.  The amount of occasional profits, if any, which are earned – What are the amounts of profits in relation to the losses, and in relation to the taxpayer’s investment in the activity?  An occasional small profit one year mixed with large losses in other years, or large taxpayer investments may indicate the activity is a hobby.  

8.  The financial status of the taxpayer – What is the taxpayer’s income status aside from the activity?  Do losses in the activity pose large tax benefits for the taxpayer?  If so, the taxpayer may not be able to prove a profit motive. 

9.  Elements of personal pleasure or recreation – Is recreation or personal satisfaction an element in continuing the activity?  This element is not enough to determine whether or not an activity is a business or hobby, but must be taken into consideration with the others listed above. 
 
With all things considered and applied to the circumstances of each taxpayer; there is no “set of tests” to unmistakably determine whether an activity is a business or hobby.  If the taxpayer is within three years of the due date for the tax return of the year in which the taxpayer first engage in the activity, the taxpayer can elect to file a form 5213 to postpone the determination of hobby or business status.  This election is a “once in a lifetime” election and can only be made in the appropriate time period. 
 
An objective approach is recommended in making the decision to classify an activity as a business or as a hobby.  Keeping this in mind, consultation with a tax professional can help to substantiate the desire to pursue an activity as a business, but is not proof by itself.   One possible approach to safeguard the taxpayer from investigation by the IRS is to establish a business plan for operations.  Some things to take into consideration include:
 
How long has the activity been operating?
How long has the activity sustained losses?
What are historical sales levels?
What are historical losses?
What are historical hours of operation?
What will be done in effort to reduce or eliminate the previous losses?
What is the termination date of the business if progress is not made?
 
An important note to keep in mind is that the business plan will be unsuccessful in mitigating investigation and possible litigation by the IRS if it is not followed.  Documentation for all efforts to improve business operations must be retained to show a perpetual interest in profitability. 
 
Due to the complexity of this issue, it is advisable to schedule an appointment with one of our tax professionals prior to making the decision to classify your new activity as a business or hobby, or if you have had previous losses and are concerned your business may be classified as a hobby in the future.  You can schedule an appointment by visiting us on the web at www.ssccpas.com or by calling us at 785-272-4484.