The Internal Revenue Service (IRS) reminds every taxpayer to follow certain guidelines when identifying whether an activity is a business or a hobby. Taxpayers must be educated about their filing obligations as it has implications for deductions. This article presents the IRS guidelines for determining whether an activity passes for a business and what restrictions apply if it qualifies as a hobby.

Factors determining whether an activity is a business or a hobby

In order to determine whether an activity is a business or a hobby, you must take into consideration the following factors: whether the effort and time intend to make a profit, whether it makes a profit in some years, whether the taxpayer depends on income from that activity, and whether the taxpayer or his/her advisers possess the know-how required to operate the activity as a business.

Moreover, you must address the following questions: Have you changed methods of operation in attempts at improving profitability? Have you made a profit in related activities in the past? Can you make a profit in the coming years from the appreciation of assets used in the activity? If you incur losses from the activity, are they because of circumstances beyond your control or did the losses occur in the start-up phase of the activity?

So when is an activity a business or a hobby?

In general, an activity is a business if it's being run with the reasonable expectation of making a profit. It is presumed that activities are operated to make profits if they earn profits during at least three of the last five tax years. On the other hand, an activity is a hobby if it doesn't intend to earn a profit.

Losses from activities

Activities produce a loss when the related expenses exceed income. In not-for-profit activities, losses from activities may not be utilized to offset other income. The limitation on not-for-profit losses is only applicable to individuals, partnerships, S corporations, trusts, and estates. This limit is not applicable to corporations other than S corporations.

Deductions for activities

Deductions for activities must be taken in this order: Deductions that you may take for personal and business activities (for example, home mortgage taxes and interests) may be taken in full. Deductions that don't lead to an adjustment to basis (advertising, insurance wages and premiums) may be taken next if the deductions from the previous category is less than the gross income for an activity.

Deductions for business activities that reduce the basis of property (like amortization and depreciation) are taken last if the deductions taken in the first and second categories are less than the gross income for the activity. Deductions are taken only to the extent stated in each of the aforementioned categories.