Under the federal tax code, there’s a fine line between businesses and hobbies. You may think of that unincorporated sideline activity you engage in an— such as a marketing director by day and an artist on the nights and weekends —as a business and hope to deduct any losses on your personal tax return. But the IRS may disagree and reclassify the money-losing activity as a hobby.

The hobby loss rules aren’t taxpayer friendly in general. However, there’s a hint of hope: there’s a good chance you can win the argument and establish that you have a business rather than a hobby if you heed the rules. Here’s some guidance, along with a recent example of a taxpayer who ran afoul of the rules.

Hobby Loss Rules

If you generate a net tax loss for the year (deductible expenses in excess of revenue) from operating an unincorporated for-profit business, you can generally deduct the full amount of the loss on your federal income tax return. So, the loss can be used to offset income from other sources and reduce your federal income tax bill.

The tax results are less favorable, however, if your money-losing side activity is classified as a hobby, which essentially means an activity that lacks a profit motive. In that case, you must report all the revenue on your tax return, but your allowable deductions from the activity are limited to that revenue. In other words, you can never have an overall tax loss from an activity that’s treated as a hobby, even if you lose tons of money.

In addition, the total amount of allowable hobby expenses (limited to income) must be treated as a miscellaneous itemized deduction item, which means you get no write-off unless you itemize. Even if you do itemize, the write-off for miscellaneous deduction items is limited to the excess of those items over 2% of your adjusted gross income (AGI). The higher your AGI is, the less you’ll be allowed to deduct. High-income taxpayers can find their allowable hobby activity deductions limited to little or nothing.

Finally, if you’re subject to the alternative minimum tax (AMT), your hobby expenses are completely disallowed when calculating your AMT liability.

Your money-losing hobby can add to your taxable income after applying all of the tax-law restrictions, which makes the hobby loss issue an IRS hot button. That’s because you must include all the income on your return while your allowable deductions may be close to zero.

A Silver Lining: IRS Safe Harbor Rules

How can you determine whether your money-losing side activity is a hobby or a business? There are two safe harbors that automatically qualify an activity as a for-profit business:

1. The activity produces positive taxable income (revenues in excess of deductions) for at least three out of every five years.
2. You’re engaged in a horse racing, breeding, training or showing activity, and it produces positive taxable income in two out of every seven years.

Taxpayers who can plan ahead to qualify for these safe harbors earn the right to deduct their losses in unprofitable years.

Intent to Make Profit

You may still be able to treat the activity as a for-profit business and deduct the losses even if you can’t qualify for one of these safe harbors. How? Basically, you must demonstrate an honest intent to make a profit. Factors that can demonstrate such intent include the following:

• You have expertise in the activity or hire expert advisors.
• You spend enough time to justify that the activity is a business, not just a hobby.
• You conduct the activity in a business-like manner by keeping good records and searching for profit-making strategies.
• You’ve been successful in other similar ventures, suggesting that you have business acumen.
• The assets used in the activity are expected to appreciate in value. (For example, the IRS will almost never claim that owning rental real estate is a hobby even when tax losses are incurred for many years).

The U.S. Tax Court will also consider the history and magnitude of income and losses from the activity. In general, occasional large profits hold more weight than more frequent small profits, and losses caused by unusual events or bad luck are more justifiable than ongoing losses that only a hobbyist would be willing to accept.

The degree of personal pleasure you derive from the activity is also a factor. For example, running film festivals in lively college towns is a lot more fun than, say, working as a finance executive — so the IRS is far more likely to claim the former is a hobby if you start claiming losses on your tax returns.

Another consideration is your financial status — if you earn a large income or most of your income from a full-time job or another business you own, an unprofitable side activity is more likely to be considered a hobby.

Toeing a Fine Line

Filler & Associates or your tax advisor can help you create documentation to determine and prove that you’re on the right side of this issue.

Taxpayers will prefer to have their side activities classified as businesses because business losses are fully deductible; hobby losses are not. The Tax Court has concluded over the years that a number of pleasurable activities could be classified as for-profit businesses rather than hobbies, based on the facts and circumstances of each case.