The Internal Revenue Service (IRS) uses a series of nine factors to decide if an activity is a business or a hobby, which helps to determine if losses are tax deductible or not. A valid business is allowed to deduct a wide range of costs related to the business operation, even if it cannot show a profit. A person engaged in a hobby cannot usually deduct the costs of the hobby.
This is a determination of whether an activity has been carried on in a manner appropriate for a business. This includes how the records are kept and whether or not the venture adjusts operations in an attempt to be profitable. If the IRS determines the activity was not operated in a business-like manner, losses will not be considered to be business losses.
Expertise and Involvement
The owner of the venture should be knowledgeable about the type of operation he is running. He should be able to show that he has made a reasonable effort to learn what he must know to operate such a business profitably. He should also be involved in the daily running of the business, or have hired suitable people to run it. If the owner fails to demonstrate adequate knowledge of and involvement in the business the IRS will most likely class it as a hobby.
Business losses are more likely to be accepted by the IRS if the owner can show that the business has assets such as real estate, or registered livestock that are expected to increase in value over time. This helps to demonstrate that the activity is being engaged in for profit, even if it shows a loss at first.
Personal and Business History
The IRS will look at two aspects of the business owner's history to help to determine if losses are to be considered business losses. If the owner has a history of other successful business ventures, the current operation is more likely to be considered as a genuine effort to make money. An owner that can demonstrate a valid effort to run a profitable business, but has had some setbacks, may still have business losses accepted by the IRS.
Any profits earned by the activity will be scrutinized by the IRS and compared to the amount of losses. In general, the IRS expects to see a profit at least two out of seven years when a business first launches. If the profit years are very small and the losses in other years are very large, the IRS may decide that the losses do not constitute actual business losses.
If the owner can show limited income from other sources, the IRS is more likely to accept that the owner is engaged in an activity with the intent of making a profit. This will generally result in any losses being accepted as valid business losses, and they will typically be deductible.
If an activity appears to be solely for the owner's pleasure and there is no evidence of a profit motive, it is most likely going to be determined to be for recreation and not a business. This means losses will not be able to be deducted from the owner's taxes.
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