I recently met with a new client who was audited on a tax return he prepared and e-filed in the prior year. The only change on his return was the reclassification of a Schedule C business to a hobby. When that occurs, losses cannot be deducted, as expenses are only allowed to the extent of business income.
Here were the circumstances of my new client for the year he was audited:
- He showed a loss on his tax return for the past six years and consistently ran the business in the same manner each year.
- The average gross receipts were approximately $1,000 with average expenses of $12,000, resulting in an average net loss of $11,000 for those six years.
- The taxpayer had a separate full-time job where he worked an average of 45 hours a week. He averaged five hours a week working on his business.
- He did not keep separate records for his business. All income and expenses were run through his personal checking account.
The IRS determined the activity was a hobby by applying these nine factors:
- The manner in which the taxpayer carries on the activity – is it run like a business and are accurate books and records are maintained?
- The expertise of the taxpayer or his or her advisors.
- The time and effort expended by the taxpayer in carrying on the activity.
- Expectation that the assets used in activity may appreciate in value.
- The success of the taxpayer in carrying on other similar activities in the past.
- The history of income or losses of the activity.
- The amount of profits, if any, which are earned.
- The financial status of the taxpayer – is this the only source of income or do they also have income from another source?
- Is there an element of personal pleasure or recreation?
While each factor does not have to be met in order for your business to qualify as a business, the more factors that are in your favor definitely help your position with the IRS. While his circumstances appeared to scream hobby, my new client may have been able to prove his position by simply meeting a few of the factors. For example, he may have been able to prove that his business assets increased over that time period. Or that he made specific business changes during the years to try make it profitable but those changes simply didn’t work. By lifting these items to the auditor’s attention, he may have been able to prove his activity was a business versus a hobby.
If you are unable to meet one of the business activity items noted above, that is fine. However, you should continually find ways to change the manner of your activity so that it meets as many of the requirements as possible. Doing so will allow for less stress if your tax return ever comes under IRS scrutiny.
By: Joe Turnes, CPA
If you are concerned about whether you have a business or a hobby, please feel free to contact one of our CPAs at (616) 642-9467 or request a complimentary accounting consultation.
