Generally, a business is considered “For Profit” if the business generates a profit in at least three out of five consecutive years. For training, showing, breeding, or racing horses, then the business needs to generate a profit for two out of seven years. What if the business does not meet this test?
Three out of five years rule
The simple test to determine if a business is considered “For Profit” is the three out of five consecutive years rule (two out of seven consecutive years for training, showing, breeding, or racing horses)
Example 1
This business is considered “For Profit.” For three out of five consecutive years the business earned a profit.
| Year 1 | -2,000 | Loss |
| Year 2 | 1,000 | Profit |
| Year 3 | 500 | Profit |
| Year 4 | -3,000 | Loss |
| Year 5 | 1,000 | Profit |
Example 2
This business may or may not be considered “For Profit.” For three out of five consecutive years the business did not earn a profit.
| Year 1 | -2,000 | Loss |
| Year 2 | 3,000 | Profit |
| Year 3 | 2,500 | Profit |
| Year 4 | -500 | Loss |
| Year 5 | -1,000 | Loss |
What if you do not meet the three out of five year rule?
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. Under Reg. 1.183-2(b) there are 9 factors that are reviewed.
1. The manner in which the taxpayer carried on the activity;
2. The expertise of the taxpayer or his/her advisors;
3. The time or effort expended by the taxpayer in carrying on the activity;
4. The expectation that assets used in the activity may appreciate in value;
5. The success of the taxpayer in carrying on other similar or dissimilar activities;
6. The taxpayer’s history of income or losses with respect to the activity;
7. The amount of occasional profits, if any, which are earned;
8. The financial status of the taxpayer; and
9. The presence of personal pleasure or recreation.
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.
The next blog will further evaluate each of the 9 factors.
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 need assistance on determining if your business “for profit” or hobby, don’t worry and don’t delay, get the Tax Help you need now. Call ALG Tax Solutions 855-MI-Tax-Help (855-648-2943) or provide your contact information online.
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.
Great Article AJ