Is It a Business or a Hobby? The Profit Motive Test and What It Means for Deductions

Side ventures are a common start for small businesses, and they often begin at a loss. That creates a question: can the losses be deducted against other income? The answer turns on whether the activity is a business or a hobby. The distinction matters more than it used to, because hobby expenses are no longer deductible.

Why the label matters

• Business: income and expenses are reported on Schedule C (or another schedule), expenses are deductible against income, and a net loss can offset other income subject to loss limitation rules. Net profit is subject to self-employment tax.
• Hobby: all income is reported, generally as other income, but expenses are not deductible under current federal law, since miscellaneous itemized deductions subject to the 2 percent floor are suspended. So you pay tax on revenue without offsetting costs, other than perhaps the cost of goods sold. Hobby income is not subject to self-employment tax.

An activity that produces losses year after year as a hobby provides no tax benefit. An activity mistakenly deducted as a business may be challenged.

The core standard

To be engaged in a trade or business for the purposes of deducting expenses, you must be involved in the activity with continuity and regularity, and your primary purpose must be to make a profit. The profit need not be reasonable or likely. The intent must be genuine. Courts and the IRS look at objective facts, not merely what the taxpayer says.

The nine factors

Regulations list factors considered together. No single factor controls:

1. Manner in which the activity is carried on. Complete and accurate books, a business plan, a separate bank account, changes in operations to improve profitability.
2. Expertise of the taxpayer or advisers. Study of the field, consultation with experts, and following their advice.
3. Time and effort expended. Substantial personal time, or hiring competent help if you spend limited time.
4. Expectation that assets used in the activity may appreciate. Especially relevant to land or collectibles.
5. Success in other, similar activities. History of turning around unprofitable ventures.
6. History of income or losses. A history of losses in the start-up phase may be normal, while continuing losses beyond a reasonable start-up period suggests a hobby. Losses caused by circumstances beyond your control help.
7. Amount of occasional profits earned. Modest occasional profits with a chance of substantial profit suggest a business.
8. Financial status of the taxpayer. Having other substantial income can suggest the activity is a tax shelter, although it does not by itself make something a hobby.
9. Elements of personal pleasure or recreation. Enjoyment does not make it a hobby, but an activity that is primarily recreational raises questions.

The three-of-five presumption

If an activity shows a profit in at least three of the last five tax years (or two of seven for activities involving breeding, training, showing, or racing horses), the law presumes it is engaged in for profit. The presumption is rebuttable. Taxpayers who do not meet it can still show profit motive under the factors. A taxpayer can also elect to postpone the determination for a period, using a specific IRS form, which delays challenges until the fifth (or seventh) year, but the election has consequences for the statute of limitations and should be considered carefully.

Documenting business intent

• Write a business plan, even a short one. Include revenue goals, pricing, marketing, and a path to profit.
• Separate finances: open a business account and keep books. See separating personal and business finances and bookkeeping systems for small business.
• Register and protect: business licenses, entity formation, insurance, website, and business cards demonstrate commitment. See how to form an LLC.
• Market actively: advertising, outreach, and pricing decisions show profit-seeking.
• Track time: a log of hours spent on business tasks.
• Get education: courses, mentors, and advisers.
• Adjust: if it is losing money, document changes made to improve results, such as raising prices, cutting costs, or changing products.
• Monitor profit and loss monthly and act on the results.

Startup phase

New businesses often show losses in early years. Courts recognize that a startup phase may be lengthy in some industries, particularly those with high upfront investment. Keep records showing why losses are occurring and what steps you are taking to reach profitability. See startup and organizational costs for the rules on pre-opening costs, which apply only if the business actually begins.

Losses and other limitations

Even if an activity is a business, deducting a loss against other income can be limited by:

• Basis and at-risk rules for owners of pass-through entities.
• Passive activity rules if you do not materially participate.
• The excess business loss limitation for noncorporate taxpayers.
• Net operating loss rules for carryforwards.

See tax basis basics.

If your activity is a hobby

Report the income. You cannot deduct expenses (except cost of goods sold or certain items reported elsewhere). If you sell items, the cost basis of the inventory may still reduce gross income. If you later turn the activity into a business, from that point on, you can deduct expenses. Some owners deliberately keep a hobby as a hobby, if it is small and enjoyable, to avoid self-employment tax and compliance.

Typical situations

• Creative work: selling art, photography, music, writing. The question is whether you approach it as a business, with regular sales efforts and pricing.
• Collectibles and resale: frequent buying and selling with a profit focus can look like a business. Occasional selling of personal items is not.
• Farming and animals: special rules for horse activities and other agricultural ventures.
• Short-term rentals and vacation homes: separate rules for personal use days.
• Online content and influencer activity: regular posting with revenue, marketing, and analytics can show intent.
• Consulting on the side: often clearly a business if you market services and invoice clients.

Common mistakes

1. Deducting losses without keeping records.
2. Mixing personal and business spending.
3. Ignoring the activity for years, while continuing to deduct losses.
4. Claiming business status for recreational travel or personal items.
5. Failing to make changes after repeated losses.
6. Not registering or formalizing an activity that generates significant income.

If you run a side venture and want to be sure your treatment can withstand questions, AE Tax Advisors can help you document and evaluate it, and a discovery call is a simple first step.