My Business isn’t a Hobby! Right? | IRS Hobby vs Business

January, 17 2025 by Carolyn Richardson, EA, MBA

It seems like everyone now is monetizing everything they do, from making YouTube or TikTok videos of their vacation, buying and opening toys for their children, and other pleasurable activities, to actually giving business advice on how to draw people to your website or giving tax advice. And many people may be thinking that, as long as they are making some money from recording how they cook dinner, they have a business, even if the money brought in is barely covering their expenses (or not covering them at all, but hey! It’s fun, so let’s keep doing it). But did you know that if you try to claim these activities on your tax return, the IRS may determine you don’t have a business after all? This is particularly true if your activity is losing money consistently.
 

How does the IRS define a “hobby”?

The Internal Revenue Code never uses the word “hobby.” Rather, it refers to an activity that the taxpayer is engaged in for pleasure more than monetary gain as an “activity not engaged in for profit.” And while the law requires you to report any income you receive from these activities, it limits what you can deduct as expenses against that income. The term “hobby loss” is shorthand for an activity that may generate income but is not engaged in with the necessary intent to make a profit on a regular and consistent basis, raising it to the level of a trade or business. These types of not-for-profit activities may include actual hobbies such as sewing, car racing, or animal breeding, but they may also include activities that taxpayers engage in that occasionally generate income. I will use the term “hobby loss” throughout this blog to describe these losses, as it’s less cumbersome than “not-for-profit activity.”

Taxpayers who incur a hobby loss are not allowed to use that loss to offset other income. Deductions that are related to such an activity are limited to the income from that activity, and certain deductions will take precedence over others.

Certain types of activities are more likely than others to be questioned by the IRS as a hobby loss. Where the taxpayer’s activity produces significant personal pleasure, or has some sport or recreational aspect, it is more likely to be questioned as a hobby. Hobbies, unlike businesses, are more often engaged in for self-satisfaction than for profit. And due to that personal satisfaction or enjoyment level, taxpayers are also more likely to continue to pursue this type of activity regardless of whether it actually generates income, or how much they need to spend to support the activity. The IRS guidelines for its auditors include such activities as farming, fishing, horse racing, training, or breeding, craft sales, auto or motocross racing, writing, airplane or yacht charters, and pretty much anything the IRS determines is an activity that the taxpayer is not conducting in a business-like manner.
 

Presumption of Profit – the 3 out of 5 Year Test

Since many businesses start out in their initial years incurring losses, it is not always clear cut in the early years of an activity if the activity is one engaged in with a profit motive or not. This is taken into account by carving out a “presumption of proof” that an activity is one engaged in for profit. Under this presumption, an activity will be deemed to be engaged in for profit if it produces a profit in at least 3 out of 5 consecutive years. If your return is being audited, the period ends in the year under examination. This accounts for a normal two-year startup period during which losses normally occur. If the activity cannot meet this presumption, the taxpayer has the burden of proving that the activity is engaged for-profit and is truly a business in the event of an audit. For activities that involve horse breeding, racing, training, or showing, there is a presumption that the activity is not a hobby loss if it has profits for 2 out of 7 consecutive years, but this rule cannot be used for other types of animal activities (I guess the horse lobby is pretty influential).

However, just because an activity shows a profit for the required number of years doesn’t necessarily mean it’s not a hobby. In a court case¹ decided in 2017, the taxpayer was engaged in car racing and had the requisite three years of profit until the Court looked at his expenses in detail. Once they took a closer look, it was determined that the taxpayer had not claimed all his expenses attributable to the activity (to the tune of about $10,000 additional expenses per year, when his net profit was under $5,000 per year), and that he was also misclassifying some of his hobby expenses as unreimbursed employee business expenses. These facts turned those three years of profits into losses, and the taxpayer lost his court case on the hobby loss determination for the years when he reported losses.
 

The Nine-Factor Test

The IRS uses a nine-factor test in considering whether an activity is one that is engaged in for profit, or a hobby loss:

1. The manner in which the taxpayer carries on the activity. In other words, are you running the activity like a business? Do you keep accurate books and records of the income and expenses? Do you have a business plan? Do you change procedures to prevent losses? Or do you just throw everything into a shoebox and think you’ll figure it out when you do your tax return? Keeping accurate and complete records will weigh this factor in your favor.
2. The expertise or experience of the taxpayer’s advisors. While it’s not a requirement that you yourself are an expert, if you do not have some sort of expertise or prior experience in the field, the IRS generally expects you to consult people who do have expertise in the field to get some knowledge on the fine points of the business. Another consideration may be your educational background as well. While you may not have any prior experience in costuming, having an art degree from a fashion school would play in your favor here. On the other hand, being a chemistry grad from USC isn’t going to be a big help when it comes to your wedding dress business. This factor is weighed more heavily against you if you don’t research your business or consult with others who might help you stem the flood of losses. Researching your activity and becoming something of an expert, or asking other experts, will help you. Documenting your research or consultations is a good idea.
3. The time and effort the taxpayer expends on the activity. One thing the IRS generally looks at here is how much time you spend on your activity versus how much time you spend on other activities, such as your regular day job (if you have one). Spending a lot of time on the activity, however, may not help you. If you are actively engaged in an activity that you enjoy (like sewing or crafting), you’d probably be spending that time anyway regardless of the money it makes or doesn’t make. Another important factor is that, even if you are spending a lot of time on the activity, is it productive time? Are you making more inventory to sell or actively selling during that time? Or are you just shopping for more “inventory” that you’ll eventually, maybe, use? If you have a job that requires you to work 60-hour weeks, and you only occasionally can devote a weekend to your own business, you aren’t likely to prevail on this factor. You need to spend enough time on the activity to make it successful.
4. The expectation that the assets used in the activity may appreciate in value. This factor is more commonly used in horse breeding or other farming operations, where land or real estate is a considerable portion of the activity and contributes to whether or not it can show a profit. While you may be working out of a room dedicated to your business out of your home, the IRS generally will not factor that into its calculations since home sale gains are excludable up to $250,000 (if you file single) or $500,000 (if you file joint with your spouse).
5. The success of the taxpayer in carrying on other similar or dissimilar activities. Have you been in business before? Was it a successful business? Even if your prior businesses had nothing to do with the current one, being able to show that you know how to run a business helps. Having a proven track record in a profitable activity goes a long way in showing that this activity, while not profitable yet, will eventually become so. And the IRS will not consider your current full-time job, regardless of how highly it is paid, to be a contributing factor in your favor.
6. The taxpayer’s history of losses from the activity. This factor is one of the most important factors, and in fact, the IRS considers it to be the most important factor. It’s also the hardest of the factors to overcome if it is not in your favor at the outset, because the IRS already knows what your history of losses are. They are sitting there on your tax returns, and it takes a few clicks of a mouse to see them. Be careful not to fall victim to what I call “deduction creep” which I explain later in this blog.
7. The amount of occasional profits earned from the activity. Generally, with most of the hobby activities I’ve encountered, the taxpayer never reports any profits. Or they report less than $1,000 of profit one year (usually the first year of the activity in which they suddenly decide they are a business because they picked up some extra income), and every year after that has little or no income and large expenses. Generally, the IRS will look at the facts and circumstances regarding what may have impacted the profits. For example, in one court case, the court decided a horse breeding activity was for profit even though the taxpayers were losing millions of dollars because they also had a $2 million gain on the sale of their prior land holdings in one year.
8. The taxpayer’s financial status. If a taxpayer is relying on the income generated from an activity to live on, this factor tends to weigh in their favor. Having substantial income from another activity, particularly if the losses from the hobby activity generate substantial tax benefits from the reduction in taxes that results, will weigh against the taxpayer, particularly if there is a large element of personal pleasure or recreation. One way the IRS looks at this is if the taxpayer can afford to continue on with the activity regardless of the continued losses, then the activity is a hobby. In fact, in the court case involving the horses I mentioned earlier, this factor initially was not in the taxpayer’s favor as they had substantial investment income from selling a large business prior to starting the horse breeding operation.
9. The elements of personal pleasure or recreation derived from the activity. Like the history of losses, this factor is the one that dooms most hobby activities when it comes to an audit. While it may not make sense that you have to dislike your business or do something you don’t enjoy fully in order to get a tax deduction, that is essentially what this comes down to. For example, if you’ve been a long-time recreational sewer and crafter for 20 years, suddenly deciding to become a business may not go over well with the government, especially if you keep losing money at it. If you happily spent the same amount of money for 20 years and never held yourself out as a business, becoming one isn’t likely to change your outlook on the activity.

No single factor is decisive. The IRS and the courts review all the factors in relation to the taxpayer’s activity and decide whether the factor favors the taxpayer, or the IRS, or is neutral. The weight of the factors can vary depending on the facts and circumstances of the case. Even if most of the factors favor the taxpayer, it is still possible for the IRS to determine that the activity is a hobby loss, and for the court to agree with that determination. The Courts give more weight to objective facts than the taxpayer’s statement of his or her intent.

Also, having a profit motive in an earlier year of the activity does not mean that the taxpayer still has one in the year of examination. The taxpayer has the burden of proving that they are engaging in an activity with an actual and honest objective to realize a profit on an ongoing basis. This is sometimes referred to as “the prudent man rule”, which comes out of a court ruling made in 1830 in Massachusetts². Under the Prudent Man rule, the court directed the taxpayer “to observe how men of prudence, discretion, and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds.” Or, in other words, are you willing to keep throwing money at an activity that will clearly never show a profit? If so, then you are not acting in a prudent manner, and do not have a business.
 

What Happens if the IRS Decides my Business is a Hobby?

When an activity is deemed to be a hobby, the expenses are allowable up to the amount of income earned from the activity. There is a caveat, however: the income is treated as gross income (front page of the Form 1040) and the expenses are treated as miscellaneous itemized deductions, subject to the 2% floor. And under current law, these miscellaneous deductions are not allowed at all! This might change after 2025 if the TCJA is not extended, but it remains to be seen.

This doesn’t mean you lose ALL your deductions, however. If the deduction is allowable under some other provision of the law, such as mortgage interest or real property taxes, those are still deductible even if you tried to claim a home office deduction. And in many cases, the auditors will permit taxpayers to deduct other expenses up to the amount of the income, provided you can show a legitimate business purpose and document the amount.
 

Postponing a Hobby Determination

If you have just recently started your business and have the misfortune to get audited in the first three years of your operations, there is an option you may want to exercise which will postpone the IRS determining that you are a hobby. The IRS allows taxpayers to essentially put the audit on hold until the presumption period has passed. This is done by filing Form 5213, Election to Postpone Determination as To Whether the Presumption Applies That an Activity is Engaged in For Profit. This election is only available for 3 years after the due date of the return where the activity is first reported. For example, if you start your business in 2024, your return is due April 15, 2025. You can file the election up to April 15, 2028. However, if the IRS audits you and challenges your activity as a hobby, you must file the election no later than 60 days after you are told the IRS determined your activity is a hobby. The election can be filed with your service center (if the Service Center is performing the audit) or with the auditor (if an office or field examination is being done).

While postponing the determination might seem like a good idea, it only works if you are certain that you can show a legitimate profit in 3 out of 5 years (the presumption period). However, don’t try to show a profit by “cooking the books” by not claiming all your expenses related to the activity or misclassifying some of the expenses as other types of deductible expenses like our court case taxpayer tried to do. The election to postpone covers the entire presumption period. If you file a joint return, both spouses must agree to the election. The main disadvantage of filing the election is that the normal statute of limitations for assessing taxes (generally, three years after you file your return) is extended for all years in the presumption period, until 2 years after the due date of the return for the last year in the presumption period.

Postponing the determination is a gamble but, unlike playing the slot machines in Vegas, you can make it pay off for you if you are truly determined to succeed in your business. On the other hand, if you know you’re just dabbling, don’t bother. Because the statute is suspended, if you fail to meet the presumption of profit during that time frame, the IRS will treat your activity as a hobby. While the automatic extension only applies to the deductions attributable to the hobby, it also applies to any deductions affected by the changes to AGI that result. Also, if you are being audited for any year in the presumption period for issues beyond the hobby loss, the IRS can assess the tax due on those anyway. But if you disagree with those adjustments and want to file an Appeal, then you must wait for the presumption period to run for those adjustments to be appealed as well. Interest and penalties are assessed from the time the return was originally due, so they continue to accumulate while the statute is suspended. Posting a bond to cover the potential liability can help reduce the penalties and interest should you lose your appeal.
 

Who Do You Call – TaxAudit!

Handling an IRS audit of anything on your return can be scary enough, but with a hobby loss audit where so many of the factors can be subject to interpretation, it pays to have a tax professional on your side. Frankly, when it comes to hobby loss audits, we have seen the IRS make many mistakes on the audit report. Sometimes, they just remove Schedule C without moving the income to Form 1040; other times, if they have selected specific expenses on Schedule C, they only disallow those expenses. In many cases, because the auditors may have made an error, it may be more beneficial to agree to the audit report they present rather than trying to appeal the decision, but that’s where the helpful tax professionals at TaxAudit can help. Not only can our licensed tax professionals represent you in the audit and argue your case, but they can also calculate best and worst-case scenarios regarding the audit outcome to see if the audit results in a more favorable outcome than anticipated.


(1) Stettner v. Commissioner, T.C. Memo 2017-113 (June 14, 2017)
(2) Harvard College vs. Amory 9 Pick. (26 Mass) 446 (1830)