Last week we talked about hobby losses and what owners can do to show the IRS that they are actually in business to make a profit. This week, I want to talk about what happens if the IRS does not agree and classifies their business as a hobby.
This does not sound like a fun conversation.
- I know right. Unfortunately, there are a number of businesses out there that cannot show that they have a true profit motive. And if they cannot do this, the IRS will not allow the business to take a loss on their return. And to make things worse, they may have to pick up income on their return.
Just to remind listeners, they can go back to last week’s show to see what can be done to show a profit motive.
- Thanks for mentioning that Terry as people can go to our website (hawkinsash.cpa) or YouTube, iTunes or other streaming services to hear that show.
So if a business is classified as a hobby what happens?
- First of all, any losses taken for the year will be disallowed. This increases your taxable income and additional tax, interest and penalties may need to be paid.
Will the IRS allow any deductions?
- In most cases, they will allow only enough deductions to offset income. They will not allow any losses.
- But in some cases the deductions allowed will not be enough to cover the income.
How does that work?
- In these cases, the IRS will allow the hobby to deduct direct business expenses, but in general, will not allow any non-direct expenses. By not deducting they costs, not only will the loss not be allowed, but some of the income may not be able to be offset.
What kind of indirect costs are we talking about?
- It’s actually more than you think. The direct costs are anything that could be considered to be cost of goods sold, so things like materials, inventory and subcontractor costs for those hobbies that make something.
- For much of the gig economy, it would be things like gas and other car expenses, especially if you are driving for Uber/Lift or doing delivering anything.
- But when it comes to what the IRS considers to be indirect, it includes most items below the gross profit like on a Schedule C and includes things like the home office deduction, but also a lot of other expenses such as insurance, selling expenses, office supplies and depreciation.
- The indirect costs that are allowed are things like mortgage interest and real estate tax.
Has this changed over the years?
- It actually had. This changed in 2018 when there was a change in the itemized deductions.
- Pre 2018 the indirect expenses could be deducted as itemized deductions, but this went away with that tax bill.
Do the hobby loss rules apply only to an individual?
- Actually not. They apply to partnerships, s-corporations and limited liability companies also.
- They do not apply to c-corporations since if they have a loss, they cannot take it anyway. It is carried forward to future years.
Be sure to talk to a tax professional if you have any questions about your hobby or business.
As a partner, I have thorough experience providing tax services to individuals, privately held businesses, nonprofit entities and estates and trusts. I also provide compilation and review services.
