If you’re starting a business on the side — especially if it’s kinda fun such as selling your paintings or brokering Star Wars collectibles — you may be wondering if you can claim a business loss on your personal taxes against other forms of income, such as W-2 wages, interest income, or rental income.
Yesterday my client was wondering the same thing. He’s a successful land broker, and his success has given him the time and money to engage in more pleasurable business pursuits.
Of course, like many businesses, these activities won’t necessarily make him money at first, and he was wondering if he can take these deductions on his taxes to offset his other income. (In a subsequent email, he said the losses per business would probably be about $1,000 each per year.)
So what’s the answer? Can he take these losses against his other income?
Today I’m going to tell you what I told him.
“Activities Not Engaged In for Profit”
The issue here hinges on whether or not these activities are “engaged in for profit” under Section 183 of the Internal Revenue Code, otherwise known as the “hobby loss rule.”
If any activity is engaged in for profit, claiming business losses is permissible.
If any activity is deemed to not be engaged in for profit, deductions are only allowed to the extent these activities have income, that is, if these activities are running a loss, you can’t use the excess deductions to offset your other income.
Now apart the 3 out of 5 year rule that we will discuss below, the definition of “engaged in for profit” is not clearly defined. It depends on facts and circumstances, and you’ll have to prove that you were, in fact, pursuing such and such activity primarily for profit and not primarily for pleasure.
More on that later. But first, let’s talk about the bone the IRS throws taxpayers in the form of the 3 out of 5 year rule.
The 3 Out of 5 Year Rule
The IRS understands that most businesses getting off the ground take some time before becoming profitable.
So to make things easy, they have a “3 out of 5” year rule. If your business shows a profit for 3 or more years out of 5 consecutive years, then it’s presumed to be a for-profit business activity.
So the IRS essentially “gives” you 2 years to get your business profitable.
However, if you don’t show a profit by Year 3, the IRS’ presumption is that your activity is not being engaged in for profit, and they may send you a notice in the mail letting you know that they are questioning whether your business is truly a business being run for profit.
This doesn’t mean that all of your deductions will automatically be thrown out.
It just means that since your business is not going to show a profit for 3 out of 5 years, you’ve lost the presumption that your activity is for-profit, and the burden is now on you to show that despite showing losses for 3 years, the activity is a bona fide for-profit business.
How Can You Show Your Activity Is For-Profit?
You can meet this burden by documenting fact patterns that indicating that you are running the activity in a businesslike manner, e.g.:
- actively seeking out ways to make the business profitable (e.g., write a business plan, do market research, etc.)
- operating the activity in a business-like manner (e.g., set up a business bank account, keep good books, etc.)
- seeking to grow your expertise with respect to the activity (e.g., taking classes on the activity’s industry, networking with other professionals in the industry, etc.)
- showing that it is likely that the activity will turn a profit in the near future (e.g., coming up with reasonable projections and forecasts)
Now, the IRS is particularly suspicious of activities involving certain elements of personal pleasure or recreation, so a music-related business may be under more scrutiny than, say, a trash pickup business.
And of course, the greater your loss, the greater your burden to prove that you are actually pursuing this business for profit and not merely for pleasure and that there is a likelihood that it will eventually turn a profit.
Quick Summary of the Hobby Loss Rules
Here is a quick rundown of the hobby loss rules:
- Activities are either engaged in for profit or not engaged in for profit.
- If an activity is not engaged in for profit, then you can’t use deductions from that activity to offset other income.
- The IRS presumes that an activity is engaged in for profit if it is in an income (rather than a loss) position for at least 3 out of 5 consecutive years.
- If an activity does not or is not going to show income for at least 3 out of 5 consecutive years, the burden falls on the taxpayer to prove that the activity is a for-profit activity.
- The taxpayer may meet this burden by providing facts and evidence to show that they were, in fact, running the business with the intent to make a profit.
Great. So Should I Take the Loss or Not?
Now that we’ve gone over the rules, we can get into the practical steps to take.
Practically-speaking, it wouldn’t be egregious for my client to show reasonable business losses on these activities on his next 2 years’ tax returns.
However, all the while he should make sure he’s documenting (emails, receipts, notes etc.) of all his “businessy” actions with respect to these activities.
If the activities are still in a loss come Year 3, it may be time to re-evaluate.
At this point, we have to make a decision. If a reasonable person would look at the manner in which my client has conducted an activity and concluded that he is truly running the activity primarily for profit and in a businesslike manner, we could continue showing losses and simply have our case ready if the IRS makes an inquiry.
However, if the business case is weak, it may be time to scale back the expenses on these activities and break even on Schedule C.