The IRS does not refrain from questioning money-losing ventures as possible hobby activities regardless of formal business structures – such as corporations, general partnerships, limited liability companies, S corporations, limited partnerships, and nontaxable organizations. Quite simply, an endeavor that’s not operated for the pursuit of profit is subjected to the hobby loss rules described in Enrolled Agent courses. The loss on a hobby is not deductible against other income.
The income generated by a hobby is always taxable. Expenses are deductible up to the amount of income from the activity. Unfortunately, another limitation is imposed on the deduction of expenses. Little known to taxpayers, this maneuver is a common subject of Enrolled Agent exam prep study. Hobby expenses are not netted from hobby income to determine a taxable figure. Rather, hobby revenues add to adjusted gross income, but expenses are taken as an itemized deduction.
A taxpayer who lacks enough deductions to itemize feels no tax impact from hobby expenses. Even if hobby expenses do increase a taxpayer’s itemized deductions, the effect is muted. Hobby expenses are miscellaneous itemized deductions. Tax professionals know from their EA training that only the amount of these deductions exceeding 2 percent of adjusted gross income is added to total itemized deductions. Consequently, after identifying hobby expenses that are no greater than hobby revenue, 2 percent of the money outflow is not deductible.
The main concern of the IRS is that losses on hobbies are not allowed to offset primary income sources, such as wages. Enrolled Agent tax experts must remain vigilant in ascertaining hobby situations before IRS detection. When no profit motive exists, an EA should not help taxpayers receive tax benefits caused from spending that exceeds revenue. No matter how substantial the revenue, a venture may still be exposed by conditions defining a hobby rather than a business.
Proper identification of hobbies is an extremely difficult procedure during an Enrolled Agent career. The IRS provides guidelines, but these certainly do not exhaust the entire subject. In fact, the nine factors cited by the IRS for determination of a profitable business activity are weighed within the overall context of an enterprise. An especially crucial element is that a taxpayer should conduct an endeavor in a businesslike manner to avoid categorization as a hobby. Some examples are keeping separate records and a distinctive bank account for the activity.
Other considerations are the amount of time devoted to the activity relative to other obligations, the degree of expertise possessed by the taxpayer for pursuing the activity, the amount of personal pleasure derived from the activity, and reliance upon the activity for income. The IRS realizes that an endeavor may occasionally create losses. However, perpetually unprofitable pursuits are indicative of failure to take actions that result in conversion to profitability. That is the classic definition for a hobby instead of a business.
Enrolled Agents finding hobby instances disguised as businesses know the correct tax reporting path from their professional studies. The biggest trouble is explaining hobby conditions to unsuspecting taxpayers. This is complicated because no single factor is conclusive. But a general pattern emerges from review of all facts and circumstances.
IRS Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.