What is Hobby Loss Rules ?
Do i have to pay taxes on hobby income ?
The term “Hobby Loss Rule” is quite significant and basically states that the expenditure to pursue a recreational activity which is not recouped as the law allows deduction of expense only to the extent of income earned by the hobby or recreational activity. Internal Revenue Code (IRC) §183 provides the law to curb perceived loss deduction abuses by hobbyists. Simply put , while in case of a business activity , one gets deduction of all expenses/losses incurred even if there is no profit , the same benefit is not available if the activity is treated as hobby .In case of hobbies , the expenses related to the hobby are only deductible up to the amount of any income you earned from your hobby. This is termed as hobby loss rules . The hobby loss rules apply to individuals, S corporations, trusts, estates, and partnerships, but not to C corporations.
What is a hobby ?
There is no hobby definition in Internal Revenue Code . So a dictionary meaning of hobby is needed to understand what it is . A hobby is defined as an activity engaged in for pleasure or recreation, rather than for profit. A hobby may be a profitable activity, without profit being the main reason for participating in the hobby. Section 183 of the Internal Revenue Code clearly prohibits any deduction of expense if a person is involved in hobbies and try to adjust the expense on pursuing such hobbies. The maximum that IRC allows is upto income earned out of such hobbies.
Business vs Hobby ?
The difference between a hobby and business is a gray area and obviously there will be serious tussle between a taxpayer and the IRS over its interpretation. According to the IRS, a business must actively be “engaged in trying to make a profit” in order to be considered a business. The IRS will examine your case on a number of parameters to decide if your claim of doing a business does not fall under the category of hobby . Some example criteria for deciding the issue of hobby or business are following :
- How do you carry on the activity?
- Do you or your staff has expertise to carryout the activity?
- How much time and effort you put into carrying out the activity?
- What is your expectation about appreciation in your investments ?
- Do you have any experience in carrying on similar or dissimilar activities?
- Is there a history of income or losses with respect to the activity
- Do you maintain account of occasional profits, if any, that are earned?
- What is your financial status
- How much personal pleasure you get out of activities ?
There is 3 out of 5 years profit principal for deciding if an activity is a business .The IRS presumes that you carry on an activity for profit if one of these applies:
- You earn profit out of activities in at least three of the last five years.
- If you carry any of the following activity, then you earned profit in at least two of the last seven years:
- Breeding horses
- Showing horses
- Training horses
- Racing horses
When can you deduct hobby losses ?
The only way you can deduct the expense or losses if the activity is for profit. The Hobby loss rules under section 183 of the IRC says that you can deduct the hobby loss on an activity only if you can prove that the activity was with a profit motive you can prove, then the hobby loss rule applies. Under the Tax Cuts and Jobs Act, you have to report all of your income , but can’t deduct any of your expenses. This is because of the suspension of the miscellaneous itemized deduction subject to the 2%-of-adjusted-gross-income threshold. The hobby loss rule applies to individuals, and not to C corporations.
In a recent case, Potter, TC Memo 2018-153 a person in business did cowboy mounted shooting on the side. He entered contests and had incurred costs . He got overall loss on the cowboy activity. However , IRS did not agree . As per IRS , his claim of deductions is not correct because the activity was a hobby.
However , the Tax Court allowed the claim of hobby loss on another ground that he conducted the cowboy mounted shooting through a C corporation, and thus the corporation could claim the deductions . The Tax Code’s hobby loss rule does not apply to C corporations.