IRS Looks Closely at Hobby Linked to Cash

Thinking of going into a money-making pastime like, say, organic farming or selling bait for fishing? Fine, but be careful not to open up a big can of worms.

In any venture of this sort, you can get all tangled up with tax rules on the question of what is a business and what is merely a hobby.

The distinction, hazy as it is at times, can mean big differences in the way you should conduct your enterprise and how much you ultimately make from it.

“If you engage in an activity for profit, losses from that activity may be used to offset other income,” notes H&R; Block Tax Services Inc. in its 1994 Income Tax Guide.

“On the other hand, if the activity is not engaged in for profit, it is a hobby, and expenses may only be deducted to the extent of earnings--and even then only as itemized deductions subject to the 2%-of-adjusted-gross-income floor.”

Or as the accounting firm Price Waterhouse points out, “You aren’t allowed to create a tax loss from your hobby to slash your overall tax bill.”

The simplest way to qualify your activity as a business with a moneymaking mission is to show a profit regularly.

“A profit motive is assumed if an activity results in a profit in three out of five consecutive years (two out of seven for horse farms),” says the accounting firm Ernst & Young in its Financial Planning Reporter newsletter.

“Once you have met the three-year requirement, it becomes the burden of the Internal Revenue Service to prove that the activity is not for profit.”

Alas, the bottom line is not always so easy to control. What if your good-faith efforts keep winding up in the red, and you still want to claim tax write-offs to which you feel legitimately entitled?

“The IRS generally will make determinations on a case-by-case basis,” Ernst & Young says.

The evidence Uncle Sam often considers, which has come up in numerous court cases, falls into several categories.

First of all, the questions focus on whether you operate in a businesslike fashion, keeping formal records of your finances and making earnest attempts to maximize revenue and limit costs.

If you have expertise in your chosen field of endeavor and spend a lot of time working at it, your case may be strengthened.

Also, the IRS often looks at people’s past records of success or failure in other business ventures and at their current finances.

“If the taxpayer could ill afford to carry on the activity as a hobby, he or she will have an easier time demonstrating a profit motive,” says H&R; Block.

“On the other hand, substantial income from outside sources may detract from a claim of profit motive, especially if the activity has considerable recreational value.”

That last issue--how much fun is it?--can also carry a lot of weight. “The mere fact that a person enjoys an activity does not make it a hobby,” H&R; Block observes.