Generally, it is better for taxpayers to label an activity a “business” than a “hobby.” But there’s more than semantics involved.
Strategy: Handle matters in a business-like fashion. This gives you a better chance of standing up to IRS scrutiny.
If it’s a close call, a tax law presumption may bail you out, especially if you’re a horse racing or breeding enthusiast.
Here’s the whole story: With a business, you can generally deduct your related expenses in full, even if you end up with a tax loss for the year. Conversely, expenses for a hobby can’t exceed the amount of income from the activity. Thus, you can’t claim an overall tax loss for a hobby.
To make matters worse, hobby expenses can only be written off as a miscellaneous itemized deduction item subject to a deduction threshold of 2% of your adjusted gross income (AGI).
- The courts have relied on the following factors to distinguish a business from a hobby:
- The manner in which you carry on the activity
- The expertise possessed by you or your advisors
- The time and effort you expend in carrying on the activity
- Any expectations you have that assets used in the activity may appreciate in value
- Any prior success in other similar activities
- Your history of income or losses with respect to the activity
- The amount of profits, if any, that you earn
- Your financial status
- Elements of personal pleasure or recreation.
Finally, if you show a profit in any three out of the past five consecutive years, the IRS will presume that the business isn’t a hobby. The presumption is enhanced for an activity involving the breeding, training, showing or racing of horses. In this case, you must show a profit in only two out of the last seven consecutive years.
Tip: The IRS can rebut the presumption by providing evidence the activity is a hobby.