For federal tax purposes , the income , losses and expenses of a small business are filed on the IRS form Schedule C . Sometimes , taxpayers enjoy gross income from something they consider to be a hobby . The Internal Revenue Code Section 183 allows them to deduct some of the expenses from the activity even without establishing the profit intent that would qualify it as a trade or business .

But that line can be blurry . “ It can often prove highly difficult to figure out the difference between a legitimate business that is devoted to making a profit and an activity that is not ,” says the IRS in one of its audit technique guides called “ Activities Not Engaged in for Profit .”

For an endeavor to be considered a business , it has to be carried out “ in a businesslike manner ” with “ complete and accurate books and records ,” says the IRS . The taxpayer must put in time and effort “ to show they intend to make it profitable ,” and has to depend on income from the activity for their livelihood . Taxpayers also have to consider whether any losses were beyond their control or were normal for the startup phase of their business .

There are other questions taxpayers must answer : Did they make a profit from a similar activity in the past ? Does their current endeavor profit in some years ? And by how much ? The IRS also says a business must show a net profit for three out of its first five years of operation , otherwise the agency

For an endeavor to be considered a business , it has to be carried out “ in a businesslike manner ” with “ complete and accurate books and records ,” says the IRS . considers it a hobby for tax purposes .

“ Most people are preoccupied and focused on the three-out-of-five-year rule , but that ’ s only one factor ,” says Joshua Hanover , a CPA , enrolled agent and managing director and office lead at CBIZ Marks Paneth in Boca Raton , Fla . “ It ’ s important to grasp not only what activity [ clients are ] doing but why they ’ re doing it . The same activity for one person [ could be ] a business , yet for another it ’ s a hobby .”

The IRS audit technique guide adds that examiners should be watching for many other details : Are there several years in which the business records little or no income and large losses ? Are large losses being used to offset some other income the taxpayer is recording ? Does the business or activity include elements of “ recreation and / or personal pleasure ”?

Section 183 says that if an activity is a notfor-profit hobby , then the taxpayer can ’ t take deductions for it . However , there are still some instances where they can treat it as a for-profit business , for instance if the gross income from the activity exceeds the deductions in three of five consecutive years .

Blogger Leslie Book recently tackled this subject on the Procedurally Taxing website , and said wealthy people taking Section 183 hobby losses could draw more IRS scrutiny “ when wealthy taxpayers try their hand at boat chartering in the Caribbean , dressage , running a vineyard , or writing a travel guide premised on finding the best sushi in Japan , and the activities generate losses that the taxpayer would like to use to offset other income .”

Book continued , “ Given the temporary disallowance of all miscellaneous itemized deductions [ in the wake of the Tax Cuts and Jobs Act ], the stakes are even higher when a taxpayer is deemed to not have the requisite profit intent .”

In recent years federal audits have doubled for wealthy taxpayers , and those earning more than $ 10 million saw their audit rate jump four

12 | FINANCIAL ADVISOR MAGAZINE | MAY 2023 WWW . FA-MAG . COM