Reporting hobby losses continues to be an audit red flag, it has been and will remain so.
The IRS is always on the hunt for taxpayers who year after year report large losses from hobby-sounding activities on Schedule C of the 1040 to help offset other income, such as wages, or business or investment earnings.
Revenue you collect from a hobby is taxable. But you cannot deduct the related expenses. The 2017 tax law temporarily nixed through 2025 miscellaneous itemized deductions previously subject to the 2%-of-AGI threshold, including hobby expenses.
To deduct a Schedule C loss, you must show the activity is a business. It needs to be conducted with continuity and regularity in a businesslike manner, and you must have a reasonable, good-faith objective of making a profit from it.
IRS regulations provide a safe harbor. If your activity generates profit in three out of five consecutive years (or two out of seven years for horse breeding), the law presumes you are in business to make a profit unless the IRS can establish otherwise.
The hobby-business analysis is trickier if you cannot meet the safe harbor. That’s because the determination of whether an activity is properly categorized as a hobby, or a business is then based on each taxpayer’s facts and circumstances.
IRS and the courts take nine factors into account:
- Expertise of the taxpayer and advisers.
- Manner in which the taxpayer carries on the activity.
- Time and effort put into the venture.
- Expectation that assets used in the activity may appreciate.
- Success in carrying on other activities.
- History of income and losses (the more years of large consecutive losses, the harder it is to demonstrate a profit motive unless the activity is still in its start-up stage).
- Amount of occasional profits.
- Elements of personal pleasure or recreation that one gets from the activity.
- whether the taxpayer has substantial income from other sources.
No one factor is determinative, but some are routinely given more weight.
To help with these factors the business should have a detailed business plan, a marketing plan. These should be working documents with measurables. How are you defining success at each level. What workarounds have you enabled when you have fallen short of the goals. You may also want to consider incorporating, show that you have faith in the business and its success. These help define a business.