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Hobby or business? Why does the IRS care?

Sometimes a person's hobby can also generate income that must be reported to the IRS. For example, a talented woodworker or quilter may sell valuable creations that bring in profits. The legal issue that arises is at what point is a hobby actually a business for tax purposes? The reason it matters is the way the IRS treats the deductibility of related expenses. 

Ordinary and necessary business expenses 

In general, ordinary and necessary expenses related to business activity may be deducted from taxable income, but financial loss generated by hobby activity is normally not deductible.  

If the IRS is uncertain about whether reported expenses are related to a business endeavor or to a hobby, the agency might conduct a review or audit of a return. The issue to be resolved is whether the taxpayer engaged in the related activity for profit. 

Activity for profit 

A recent June 2017 United States Tax Court case sheds light on the analysis used to answer this question. In Stettner v. Commissioner of Internal Revenue, the court found that the taxpayer's car racing activities were not conducted with an "actual, honest profit objective" during the tax year in question. 

Taxpayer intention 

Whether an activity was conducted for profit depends on whether the person honestly meant to make a profit, even if that belief was not realistic. The IRS or a reviewing court looks at the facts and circumstances of the particular situation to answer this question. 

Relevant factors 

An IRS regulation lists nine factors that can shed light on this question: 

  • How did the taxpayer conduct the activity?
  • What was the taxpayer's level of expertise?
  • How much time and effort were involved?
  • Was it likely that assets or property used to conduct the activity would appreciate or increase in value?
  • Has the taxpayer successfully engaged in similar or different activities?
  • Has the taxpayer historically earned income or taken loss in this activity?
  • How much occasional profit has been earned?
  • What other sources of income did the taxpayer have or what was his or her financial condition?
  • Did the taxpayer engage in the activity for recreation or pleasure? 

In the Stettner case, the court found that six of the factors favored the IRS and two the taxpayer, with one being neutral. Accordingly, the court found that the taxpayer had not had an "actual, honest profit objective" so that related expenses were not deductible as business expenses. 

This is only a brief look at a sometimes-complicated issue. Anyone with questions about hobbies and tax issues should talk to a tax lawyer.

 

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