If the business does make a profit three out of five consecutive years (two out of seven for training, showing, breeding, or racing horses), then the facts and circumstances will be evaluated to determine if the business is “For-Profit” or hobby. There are 9 factors that are evaluated. In the previous blog we evaluated Factors 1 – 4 of the 9 factors. This blog reviews Factors 5 – 9.
It is important to understand that neither one factor nor a majority of factors necessarily determines the outcome. The IRS may consider other factors not listed when determining if a business is “for profit” or hobby.
Factor 5: The success of the taxpayer in carrying on other similar or dissimilar activities
The taxpayer may have been successful in other businesses but the current business is not profitable. Also the taxpayer may have been involved in several businesses. Did the taxpayer abandon any of those businesses due to profitability?
Factor 6: The taxpayer’s history of income or losses with respect to the activity
A business incurring losses for 10 years will likely not establish a profit motive. There will have to be a reason beyond the taxpayers control to incur losses every year. The reasons may be injury, illness, and death or law changes. If these circumstances had not occurred, would the business be profitable? Speculative profit does not outweigh years of losses. For example, one outstanding dog for potential breeding could turn the business around. This potential may not be sufficient to establish a profit motive.
Factor 7: The amount of occasional profits, if any, which are earned
Did the business earn any profits since the business started? If there were profitable years, were the profits directly related to the business in question or another business? For example, the taxpayer had two businesses, business 1 and business 2. The IRS is evaluating whether business 2 is a hobby. The IRS reviews old tax returns to do the three out of five years test. In a couple of the old years, the taxpayer mistakenly reported sales from business 1 as sales of business 2. As a result of this mistake, business 2 was profitable. The IRS adjusted the sales numbers for business 2 and determines that business 2 was in fact not profitable.
Factor 8: The financial status of the taxpayer
The taxpayer may have other sources of income to sustain long periods of losses. If there is a recreational component associated with the business, having other sources of income to pay for business losses will likely not establish a profit motive. For example, the husband is a doctor and the wife is an engineer. Combine their salary is $300,000 per year. They have several horses which they breed and show. The couple reports the breeding activity as a business on the tax return. The business has incurred losses for 10 years. The couple can afford to sustain the losses. The couple continues to support the business because they love the horses and enjoy attending shows. This business is likely a hobby.
Factor 9: The presence of personal pleasure or recreation
The taxpayer may have a personal motive for engaging in the business. If there is a significant personal motive, then there may not be a profit motive. In terms of breeding, does the taxpayer enjoy the social aspect of attending shows? Does the taxpayer enjoy travelling to different parts of the country? Does the taxpayer enjoy being around the animals? The day to day labor to care for animals may not outweigh the love and passion the taxpayer has for the animals.
Four Part Blog Table of Contents
- Tax Consequences for Determining if a Business is For-Profit or Hobby
- For-Profit Business or Hobby, Facts and Circumstances
- For-Profit Business or Hobby, Analysis of Factors 1 – 4
- For-Profit Business or Hobby, Analysis of Factors 5 – 9
If you are being audited due to hobby loss rules, call us. Then sit back and relax, we’ll take on the IRS for you, and we love doing it! ALG Tax Solutions 855-MI-Tax-Help (855-648-2943) or provide your contact information online. We will stand shoulder to shoulder with you before the IRS.
IRS Circular 230 Disclosure: To the extent this writing contains advice on a federal tax issue, the advice is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed in this communication.