Many Americans try to supplement their income pursuing activities that they enjoy, which can include everything from creating artwork to sell at a local craft fair to fixing antique engines in their garage. While the individuals undertaking these activities may consider themselves to be operating a business, many are actually classified as hobbies by the IRS. The distinction is important because a business receives far more favorable tax treatment under the U.S. Tax Code than a hobby.

Generally, if an activity meets the IRS’s criteria for being classified as a business, a taxpayer can claim deductions based on business expenses and can take advantage of other business tax benefits. Hobbyists are usually barred from deducting any expenses from their activities but are still required to pay federal income taxes on any amounts they earn.

Section 183(d) offers a safe harbor rule to make it easier for a taxpayer to determine if their activity should be treated as a business. The rule provides a general presumption that an activity is for-profit if it results in greater revenue than deductions in three or more taxable years during a period of five consecutive taxable years, ending with the relevant taxable year. For activities consisting mostly of the breeding, training, showing or racing of horses, it is two out of seven taxable years, ending with the relevant taxable year. However, taxpayers who can’t take advantage of the safe harbor rule may still be able to show their activity should be treated as a business.

IRS’s hobby vs. business test

When addressing challenges to an IRS determination that an activity should be treated as a hobby, the courts have generally followed a nine-factor test the IRS has laid out in Treasury Regulation 1.183-2(b). No single factor controls the decision and the answers to other questions are considered. Each of the factors is considered separately and the IRS makes its determination based on whether a majority of the factors weigh in favor of the activity being treated as a hobby or business.

1. Activity conducted as a business

If the taxpayer is conducting the activity in a businesslike manner and maintaining complete and accurate records, it is generally treated as an indicator that it is being engaged in for profit. Likewise, if the activity is conducted in a manner that is similar to other activities that generate a profit, the IRS may find a profit motive. Finally, changes made to the activity to increase profits may indicate a profit motive.

2. Expertise of the taxpayer and their advisors

Did the taxpayer prepare for the activity by studying accepted business, economic and scientific practices or consulting with an expert? Preparation may indicate that the taxpayer intended to carry out the activity as a business, but failure to carry out the activity in the manner suggested by their research or expert opinion could indicate a lack of intent.

3. Time and effort spent on activity

If the taxpayer devotes much of their personal time to the activity, particularly if it does not provide a substantial personal or recreational benefit, it may indicate that the taxpayer was pursuing it for profit. Withdrawing from another occupation to dedicate more time and energy to the activity can also indicate that it was intended to be a business. However, the fact a taxpayer does not dedicate much time to an activity does not necessarily mean there was no profit motive if someone competent was employed to carry out the activity.

4. Expectation that assets used in activity could increase in value

Did the taxpayer intend for an overall profit to result due to the increased value of the land used in the activity even if the activity itself did not earn a profit?

5. Success in similar activities

If a taxpayer has engaged in similar activities in the past and turned them into profitable enterprises it may indicate that the activity is pursued for profit, even if it is currently unprofitable.

6. History of income or losses

Losses during the startup stage of an activity may not necessarily mean it was not engaged in for profit. However, if losses continue beyond the customary startup period, it could indicate that it is not being pursued for profit, unless it was the result of customary business risks or reversals. The IRS will also consider whether unforeseen circumstances, such as fire, theft, weather or depressed market conditions, led to the losses after the startup period.

7. Profits and losses relative to taxpayer’s investment

A taxpayer earning a small profit from an activity that generates large losses, or from an activity in which the taxpayer has made a large investment, does not usually indicate that it is being pursued for profit. However, occasional large profits may indicate that the activity was engaged in for a profit, even if the investment or losses were comparatively small.

8. Taxpayer’s financial status

The fact a taxpayer does not have substantial income from sources other than the activity may indicate that it is engaged in for profit. Substantial income from sources other than the activity may indicate that it is not engaged in for profit, especially if there are personal or recreational elements involved.

9. Elements of personal pleasure or recreation

The presence of personal motives in carrying out an activity may indicate that it was not engaged in for profit. Likewise, a profit motivation may be inferred if the activity lacks any appeal beyond profit. However, it is not necessary that the taxpayer be engaged in the activity for the exclusive purpose of deriving a profit.

Note: Many of the above-listed factors require that a taxpayer kept good records of their business activities, profits and losses. IRS examiners will expect the taxpayer to produce those records when assessing whether an activity is a business or hobby.

Appealing an IRS determination

If a taxpayer disagrees with the IRS’s conclusions regarding their activity, they have the option of filing an appeal with the IRS’s Office of Appeals or filing a petition with the U.S. Tax Court. However, it must be noted that both the Office of Appeals and Tax Court usually apply the same nine-factor test the IRS uses.

Looking for additional information?

If you are looking for more information on the analysis necessary to determine whether an activity is a for-profit business or a hobby, check out our on-demand webinar: Determining a Not-for Profit Hobby vs. For-Profit Trade or Business.

In recent years, the IRS has imposed preparer due diligence requirements for the earned income tax credit and penalized preparers who do not meet those requirements. This means you need to understand your clients’ due diligence obligations and what is required of them.

Below, you’ll find a few of the top questions from a recent webinar on the topic and their accompanying answers. If you choose to attend the on-demand version of this webinar, you can access the full recording and the entire list of Q&As.   

Q: Can the custodial parent release head of household (HOH) status and the earned income tax credit (EIC) to the other parent?

A: No, only the custodial parent is eligible for HOH filing status and EIC.

Q: If a taxpayer receives in-home supportive services (IHSS) income that is excludable from taxation, can it still be included as earned income for EIC purposes?

A: Yes, IHSS income (primarily a California program) is similar to difficulty-of-care payments under Notice 2004-7 and is considered earned income for EIC purposes.

Q: What are BAH and BAS? Are they included in the calculation of EIC?

A: BAH (basic allowance for housing) and BAS (basic allowance for subsistence) are not included in earned income for EIC purposes.

Q: What documents should be requested if a child is under school age and has no doctor visits?

A: Acceptable documentation includes court documents or official correspondence addressed to the child at the taxpayer’s address. Statements from social services or similar agencies confirming the child’s residence may also be used. A report card can serve as supporting documentation but should not be the sole proof.

To learn more about the requirements for the earned income credit, you can watch our on-demand webinar. NATP members can attend for free, depending on membership level! If you’re not an NATP member and want to learn more, join our completely free 30-day trial.

Question: Fred is a minister who only receives a housing allowance as payment for his services. He heard he could request voluntary federal income tax withholding (FITW) from his pay to help offset the Self-Employed Contributions Act (SECA) tax he owes. He contacted his church and was told he could not take FITW from the housing allowance he received. Why was he not allowed FITW?

Answer: Fred was not allowed FITW because his housing allowance (sometimes called a parsonage allowance or a rental allowance) is not reported on Form W-2, Box 1.

Per IRS regulations, voluntary withholding agreements established under §3402(p)(3)(A) apply to amounts that must be included in an employee’s gross income under §61. If Fred only receives a housing allowance as income, it is excluded from gross income under §107(2) and does not qualify for voluntary FITW.

Because of these regulations, ministers cannot request voluntary FITW when they receive only a housing allowance. They must have some taxable income, including salary, wages or even an SECA equivalent. Fred would have been qualified if he had received other gross income, like health insurance premiums paid by the church on his behalf or reimbursement under a nonaccountable plan.