It’s important to understand the hobby loss rules when starting a side business. For the first couple of years, it is common for a start up business to lose money. If the side business loses money for several years, the business may be a hobby. The tax consequences of reporting a business as “for profit” versus a hobby can be significant.
If a “for-profit” business loses money, then the loss can be written off on the tax return. However, if the business is considered a hobby, then expenses deductible are limited by sales. The hobby expenses are further reduced by 2% of adjusted gross income (AGI).
Example
A couple has a horse breeding business. In the current year, the business had $10,000 of sales and $12,000 of expenses. The business ended up losing $2,000 (10,000 – 12,000 = -2000). Their AGI for this year is $75,000.
For-Profit Business Can Write Off All Expenses
If the horse breeding business is considered a “for-profit” business, the couple can write off $2,000 on their tax return.
Write Offs for Hobby Expenses are Limited
If the horse breeding business is considered a hobby, then $10,000 of sales is reported on page 1 of the couple’s tax return. Then on Schedule A, the couple reports the hobby expenses. The amount of hobby expenses is limited by sales. The amount of hobby expenses to report is $10,000 because sales is $10,000. The hobby expenses are further reduced by 2% of AGI. The couple’s AGI is $75,000, 2% of $75,000 is $1,500. The $10,000 of hobby expenses is reduced by $1,500. Overall, the amount of hobby expenses this couple can deduct on Schedule A is $8,500.
This is a significant difference for the couple which could result in about $875 of additional taxes owed.
This table summarizes the tax impact of a business considered “for-profit” or hobby.
| Couple with AGI of $75,000 | Where reported on return | For-profit business | Hobby |
| Horse breeding sales | Form 1040, page 1 | 10,000 | 10,000 |
| Business expense | Form 1040, page 1 | 12,000 | 0 |
| Hobby expense | Schedule A | 0 | 8,500 |
| Taxable income (loss) | Form 1040, page 2 | -2,000 | 1,500 |
Determining whether a business is considered “for-profit” or hobby can have large tax consequences. Especially, if a tax return is audited. The IRS could potentially make an adjustment to report a business as a hobby for the last 3 years of tax returns. The tax, penalties, and interested related to adjustments made by the IRS can result in a significant amount of additional taxes due.
The next blog will review the factors on determining if a business is considered “for profit” or hobby.
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
We will stand shoulder to shoulder with you before the IRS. If you are being audited due to hobby loss rules, 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.