Do hobby loses attract IRS audits?

YES, it does. Losses from hobbies attract IRS audits. It’s cool to run a business that you enjoy, such as photography, dance studio, martial arts, dog-breeding, farming, and other leisurely activities. If you convert that stress-reducing pastime into a regular business, try to make some money; otherwise, you may attract an IRS audit, especially if your new enterprise consistently generates losses from year to year. IRS may claim that you have a hobby – an activity not engaged in for profit and therefore not deductible for income taxation.

There are two ways to avoid disallowance of hobby loss.

• The first way is to show a profit in at least three out of five consecutive years (two out of seven years for breeding, training, showing, or racing horses).

• The second way is to have a profit-making objective. Run the venture in a businesslike manner. Show that you intend to turn it into a profit-making venture, rather than operate it as a mere hobby. Open a bank account. Create books of account such as ledgers and trial balances. Generate financial statements. If you run a corporation, hold board of directors meetings as legitimate entities do. If it walks like a duck…

Under hobby loss rules, you can still claim usual deductions that are available whether or not the enterprise is engaged in business for profit (state and local property taxes).

However, your deductions for business-type expenses (rent or advertising) will be limited to the excess of your gross income, meaning that you will not end up with a loss.

Deductible hobby expenses are claimed on Schedule A of Form 1040 as miscellaneous itemized deductions subject to a 2%-of-AGI floor (beware of audit risk if you take big ticket items under Miscellaneous Expenses of Schedule A). By contrast, if the company is not affected by hobby loss rules, allowable expenses would be deductible on Schedule C, even if they exceed income from the company.

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Victor Santos Sy graduated Cum Laude from UE with a BBA and from Indiana State University with an MBA. Vic worked with SyCip, Gorres, Velayo (SGV – Andersen Consulting) and Ernst & Young before establishing Sy Accountancy Corporation in Pasadena, California.

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He has 50 years of experience in defending taxpayers audited by the IRS, FTB, EDD, BOE and other governmental agencies. He is publishing a book on his expertise – “HOW TO AVOID OR SURVIVE IRS AUDITS.” Our readers may inquire about the book or email tax questions at
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