When Is a Business Really Just a Hobby?

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.

Author: Jim Payne

Jim Payne, a Florida Certified Public Accountant (CPA) since 1976, offers candid insights on getting square with the IRS — with the least pain, and at the lowest cost — with (or without) the help of a tax representative. Mr. Payne is a former IRS agent and expert in business profitability, IRS audits, IRS payroll tax, and IRS non-filer issues. As a Tax Representative, his goal is clear: " I will speak on your behalf to all IRS agents, so you never have to, and I'll guide you in executing a strategy to resolve your IRS problem so you can get back to enjoying life."

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