The tax code gives you a tax deduction if your business loses money. However, this deduction applies only if the IRS believes that your business is a bona-fide attempt to make a profit. For people whose primary income comes from a job or an established business, it can be tempting to consider making a business out of a favorite hobby and allowing it to lose money year after year.
The IRS’ hobby loss rules define the way that the government decides whether your business is a for-profit endeavor or a hobby that is less deserving of a tax deduction.
The easiest way to demonstrate that you intend your business to make a profit is to actually make a profit. If your business has reported a profit for three out of the past five years (including the current tax year), the IRS will presume that it is a business, unless there is a reason not to. Many businesses that involve horses need show a profit only for two of the past seven years.
If your business fails these tests, the IRS will presume that it is a hobby. However, this is just a presumption. The final determination of whether a business is a profit-making venture or a hobby is based on whether the taxpayer appears to treat the activity as a business by putting time into it, advertising and modifying operations to achieve profitability.
If you have a side business, it is important to be aware of hobby loss rules that might affect your tax deductions. This article is not tax advice; if you need tax advice, please contact us.