Hobby loss audit: is your activity a business or a hobby?

The question being asked

Tax law treats activities differently depending on whether they are carried on for profit. Section 183 of the Internal Revenue Code limits deductions for an activity not engaged in for profit. The IRS says income from a hobby must still be reported, and a loss from an activity without a profit motive cannot offset other income. An exam letter on this topic usually follows a return that shows repeated losses from something like breeding dogs, selling crafts or running a small farm.

The presumption

The statute includes a presumption: an activity is presumed to be for profit if it shows a profit in at least 3 of 5 consecutive tax years, or 2 of 7 for activities consisting mainly of breeding, training, showing or racing horses. A taxpayer can also elect to delay the determination of whether the presumption applies. If you are unsure whether either rule helps you, that is a good moment to ask a qualified practitioner.

The nine factors

Treasury Regulation 1.183-2(b) lists nine factors normally considered. The regulation says no single factor is determinative and all facts and circumstances are weighed.

• The manner in which you run the activity, including whether it is businesslike and records are kept
• Your expertise or that of your advisers
• The time and effort you put in
• The expectation that assets will appreciate
• Your success in similar activities
• The history of income or losses
• The amount of occasional profits
• Your financial status
• Elements of personal pleasure or recreation

Example: weekend pottery

Consider a teacher who sells pottery at fairs and online. Her records might include a separate bank account, sales logs, a pricing sheet that accounts for materials, notes on classes she took, and a plan for moving into wholesale. Those documents speak to several factors at once: manner of operation, expertise, time and effort, and the expectation of profit.

If the same teacher had no records, no prices and no plan, the question would be harder to answer. The point is not that records win; it is that the examiner can only evaluate what you can show.

Records that help show a profit motive

Gather documents that tell the story of the activity over time: business plans, marketing efforts, profit and loss summaries, how you changed course after losses, advice from experts, and the hours you work. Pleasure in the activity does not by itself defeat a profit motive, but the regulation names it as one factor, so address it honestly.

What not to do

Do not rewrite history. Do not invent a business plan after the letter arrives; present what really existed and explain it. Do not skip reporting income from the activity while you contest the loss.

Responding in writing

IRS Audit Defense Pro is software that helps you organize your facts and draft a response letter you review and send yourself; it is not a law firm, CPA or enrolled agent. For a hobby loss exam, a letter that sets out how you operate, in the order of the nine factors, with attached records, gives the reviewer a clear path through your facts. Remember that the IRS fact sheet on this topic is from 2022, so check the IRS site for current guidance.

Frequently asked questions

Sources

• 26 U.S.C. 183: Activities not engaged in for profit
• 26 CFR 1.183-2: Activity not engaged in for profit defined
• IRS: Know the difference between a hobby and a business

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