Preface: “Happy is a man who can make a living by his hobby. “– George Bernard Shaw
Why Your Business Must Be More Than Just a Hobby
If you’re deducting losses from your business activities, it’s critical to ensure the IRS recognizes them as valid business expenses, not just costs from a hobby. Here’s what you need to know — and why it matters.
Under IRC Section 183, if the IRS determines your activity isn’t profit-driven, you can only deduct expenses up to the income generated by that activity, meaning losses can’t offset other income like wages or investment gains.
Since the Tax Cuts and Jobs Act (2017), miscellaneous deductions—including hobby losses—have been eliminated through 2025, making this distinction even more crucial.
A simple rule of thumb exists: if you show a profit in at least three of the last five years, the IRS assumes you’re operating with a profit motive, or two of seven years for horse-related activities.
The Weighting Factors Test
The IRS examines whether your activity resembles a business by weighing factors such as :
-
- Businesslike operations: Do you maintain separate books and records?
- Expertise: Have you studied the trade or consulted professionals?
- Time & effort: Is this a casual pastime or your primary focus?
- Profit history & potential: Have you turned a profit occasionally? Can you realistically expect future gains?
- Financial dependence: Do you rely on this activity for income?
- Personal enjoyment: Is this driven by passion or profit?
No single factor decides—it’s the overall picture that matters.
Example 1: A self-published novelist who alternates between profitable years and losses faces red flags. To preserve deductions, she must show businesslike behavior—marketing efforts, separate accounts, advertising expenses—and document a genuine plan to earn a profit.
Example 2: A hobby photographer who deducts significant equipment expenses but reports minimal income may have those deductions disallowed. If audited, the IRS can reclassify the activity as a hobby and only allow deductions up to the income earned.
Steps to demonstrate profit intent to strengthen your position:
-
-
- Structure your operation professionally – maintain clean financial records and business accounts.
- Develop a formal business plan – document goals, marketing strategies, and profitability milestones.
- Make proactive changes – adjust pricing, marketing, or operations if losses persist.
- Invest in growth – continue professional development or hire skilled advisors.
- Track time and expenses diligently – show you’re treating this as a serious enterprise, not a pastime
-
Why Does This Matter?
Legitimate business losses can offset other income. Clear documentation and professional conduct reduce IRS scrutiny. A plan demonstrates to lenders, investors, or partners that your operation is serious and sustainable.
Operating a business with a clear profit motive benefits not only your taxes but also your credibility and growth potential.
Entering into the hobby trap limits your deductions and increases audit risk. If you’ve claimed losses but your activity hasn’t consistently turned a profit, or your record-keeping could be stronger, now’s the time to tighten up. Need help documenting your profit intent and ensuring compliance? Schedule a consultation—we’re here to help you.