Income from a hobby is offset by expenses only to the extent of the income. Further, the expenses are supposed to be claimed only as Itemized Deductions on Schedule A of form 1040. The expenses are reduced by 2 percent of Adjusted Gross Income (bottom of page 1 on form 1040).
A sole-owner business reports income on Schedule C of form 1040 and claims the expenses on that form. If it is a loss, it offsets the other income on the return (and saves tax).
Whether the activity is a business or not depends on the facts and circumstances. IRS regulation 1.183-2: Activity Not Engaged in for Profit Defined lists several factors that help determine if the activity is engaged with an intent of making a profit. Courts have held “... a business will not be turned into a hobby merely because the owner finds it pleasurable; suffering has never been a prerequisite to deductibility. Success in business is largely obtained by a pleasurable interest therein ...”
Factors that indicate it is a business include: is the activity done in a businesslike manner with complete and accurate books and records? Even if the first years result in a loss, if the owner or advisors do extensive study and make changes with an intent to have a profit, the profit motive is supported or proven.
The time and effort expended by the owner may indicate profit intent. If much of the owner’s personal time and effort is spent on the activity that may also indicate it is engaged in for a profit.
Sometimes the profit motive is not only from the operations, but also the possible increase in value of the land, building and other assets (patents, etc.) is enough to show the profit intent.
If the owner has experienced success in prior business operations, that may indicate the present activity is for profit, even if it is not profitable at the beginning or first few years.
If losses are sustained from circumstances beyond the control of the owner, the losses would not be an indication the activity is not engaged in for profit. Drought, disease, fire, theft, weather and depressed market conditions are the kind of circumstances that are beyond control of the owner.
The financial status of the owner, such as not having substantial income or capital from other sources may indicate a profit intent. On the other hand, it usually takes a significant capital contribution and a lot of time to begin a business activity. It is OK to enjoy the business activity.
If you are trying to make a profit, any business losses are deductible and will reduce your tax.
Did you hear? “Illegal immigrants have always been a problem in the U.S. Ask any Indian,” by Robert Orben.
John Bullis is a certified public accountant, personal financial specialist and certified senior adviser who has served Carson City for 45 years. He is founder emeritus of Bullis and Company CPAs.