A few of us had dinner after a community meeting recently. One participant talked about his marketing and sales consulting side business. He was proud of his work but had a concern. What if the IRS claims his business is just a hobby and disallows the losses he’s claimed?
His concern is valid. The IRS has strict rules for deciding whether an activity is a business or a hobby. Understanding these rules can help avoid stress—and save money.
The IRS uses the “hobby loss rule.” You cannot deduct losses against your income if your activity is a hobby. The key factor is your intent to make a profit. Are you treating it like a real business? Or is it something you do casually for personal enjoyment?
The IRS considers several factors:
- Profitability: Have you made a profit in at least three of the last five years? Consistent losses may raise red flags.
- Effort and Expertise: Are you working to improve your business? Do you have the skills needed to succeed?
- Business Practices: Do you keep records, have a business plan, and market yourself professionally?
- Time and Commitment: Are you spending significant time on the activity, or is it something you do occasionally?
- Enjoyment: Does the activity bring you personal pleasure? If it feels more like a hobby, the IRS might see it that way, too.
When I shared this with the group, we laughed about the “fun test.” But it’s a serious issue. If your activity doesn’t meet these business-like criteria, the IRS may classify it as a hobby. In that case, you can report income from it but can’t deduct expenses beyond what you earn.
For the gentleman at dinner, I suggested treating his side business like a business. Keep detailed records. Focus on growth. Run it professionally. If he does, he’ll be better prepared if the IRS takes a closer look.
If you’re unsure about your side business, take a step back and evaluate. Are you running it like a real business? A little effort now can save you stress later.