This post originally appeared on Forbes.
This week, the Treasury Inspector General for Tax Administration (TIGTA) released its audit report of the IRS’s methods of addressing taxpayers who take business tax deductions for activities not engaged in for profit (i.e. hobbies). TIGTA found that the IRS can do a better job of identifying high-income taxpayers who try to offset their income with hobby losses from unprofitable activities.
Determining whether a business qualifies as a hobby is not an exact science. If the activity has operated in the black for three or more out of five consecutive years, it will generally be presumed to be a for-profit business. Individuals who engage in for-profit business activities are allowed to deduct expenses that are ordinary and necessary in carrying on the trade or business. If expenses exceed income, the loss can be used to offset other income, including wages, interest and dividends, etc. If the loss is a result of a hobby business, it cannot be used to offset other income.
If the activity is determined to be a hobby, the income from the activity is taxable and reported as Other Income on Line 21 of Form 1040. Expenses are limited to the activity’s gross income and are deducted as a Miscellaneous Itemized Deduction on Schedule A. There, they are subject to the 2% of Adjusted Gross Income limitation and the taxpayer must have enough itemized deductions to exceed the standard deduction. Otherwise, they receive no benefit at all from hobby expense deductions.
TIGTA found that the IRS does not maximize all of the relevant information available to them to identify hobby losses. Even when returns containing potential hobby losses are selected for audit, examiners do not always address the hobby loss issues.
This year’s audit was a follow-up to their previous findings. TIGTA evaluated data from 2011 through 2014. They estimate that for 2013, taxpayers may have inappropriately used hobby loss expenses to reduce taxes by as much as $70.9 million.
TIGTA recommended that the IRS make use of its research capabilities to identify individual returns with multiyear Schedule C losses and other factors that may indicate abuse of hobby loss deductions and provide better tools and training on this issue for examiners.
All is not lost if you are legitimately running a business but not showing a profit.Taxpayers have been able to convince the IRS that they were in a for-profit venture under the “facts and circumstances test.” Facts and circumstances might include the time and effort put into the business, the taxpayer’s success in similar activities, and whether the activity is performed for personal pleasure or recreation.
Bottom line? If you’re worried about your business being flagged as a hobby loss, keep thorough and businesslike books, maintain separate business checking and credit cards accounts, obtain the proper business insurance and licenses, and maintain a written, updated business plan. Otherwise, if you’ve been trying something for many years and you still aren’t making a profit, it might not be the right business for you.