If you run a business “on the side” and derive most of your income from another source (whether from another business you own, employment or investments), you may face a peculiar risk: Under certain circumstances, this on-the-side business might not be a business at all in the eyes of the IRS.
Generally, a taxpayer can deduct losses from profit-motivated activities, either from other income in the same tax year or by carrying the loss back to a previous tax year or forward to a future tax year. But, to ensure some pursuits are really businesses — and not mere hobbies intended primarily to offset other income — the IRS enforces what are commonly referred to as the “hobby loss” rules.
For example, if you haven’t earned a profit from your business in three out of five consecutive years, you’ll bear the burden of proof to show that the enterprise isn’t merely a hobby. If a profit can be proven within this period, the burden falls on the IRS. In either case, the agency uses nine nonexclusive factors to determine whether the activity is a business or a hobby — including management expertise and time and effort dedicated.
If your enterprise is redefined as a hobby, there are many business deductions and credits that you won’t be eligible to claim. You may still write off certain expenses related to the hobby, but only to the extent of income the hobby generates. If you’re concerned about the hobby loss rules, we can help you evaluate your situation.