Many taxpayers are fortunate enough to turn a hobby or an activity they are passionate about into a business. The IRS, however, too often determines that the taxpayer’s business is not a “real business” when the business loses too much money. While sometimes the IRS determination is right, many times the IRS will incorrectly re-characterize a legitimate business as a hobby. This can result in a significant loss of deductions and increased tax liability.

The IRS is most suspect of taxpayers who continue to operate a business which loses money over many years. Common sense suggests that the taxpayer should close the business to avoid future losses. Therefore, if the taxpayer continues to operate the business, the IRS concludes that it must be for a non-business reason, like deducting the expenses of their hobby. Some common targets of IRS audits include: dog, horse, and other animal breeders; race car drivers; artists; and “direct” or “multi-level” marketing businesses.

The practical effect of the IRS determining that a business is not being operated for profit is twofold. First, the IRS will disallow any deduction amounts for expenses which were greater than the business’s gross receipts. This creates a tax deficiency. Second, the taxpayer will lose the ability to carry the excess losses back to previous years or forward to future years to offset income. The consequences of these adjustments can be devastating to a small business owner.

Pursuant to Internal Revenue Code Section 183, the “hobby loss rule,” the IRS presumes that an activity is for profit when the gross receipts for that activity exceed the deductions for 3 years out of any 5-year period. If, however, the losses have continued for multiple years, the IRS will assume that the activity is not engaged in for profit. This puts the burden on the taxpayer to prove his or her profits motive. Please visit the IRS’s website for more information on the “hobby loss rule.”

When auditing a business for profit motive, the IRS considers a number of factors to determine whether a taxpayer had a reasonable expectation of making a profit. These factors are listed in the Treasury Regulations at section 1.183-2 on the Code of Federal Regulations website. In the event the Revenue Agent makes an unfavorable determination and the taxpayer believes they have the required profit motive, the taxpayer should appeal to either the IRS Appeals Division or United State Tax Court.

Even taxpayers who report many years of business losses can overcome an IRS determination that their activity was not engaged in for profit. For example, in Allen v. Comm’r, 72 T.C. 28 (1979), the U.S. Tax Court held that the taxpayer, who operated a skiing lodge and reported losses on the Schedule C to his Form 1040 tax return for 11 consecutive years, was engaged in an activity for profit because he operated the company in a business-like manner. He kept meticulous books and records, advertised, and reasonably expected the lodge to appreciate in value.

The Minnesota Department of Revenue (MDR) also re-characterizes business deductions as hobby losses if it finds that a business was not operated for profit. An MDR audit can come either before or after an IRS audit, and the MDR is not bound by any previous IRS determination.