The Internal Revenue Code
restricts taxpayers from deducting expenses for activities that are not
engaged in for profit. These are commonly referred to as "hobby
The IRS in 2007 posted on
the IRS.GOV website a fact sheet that discusses the classification of an
activity as one having a profit motive, or one that is an activity not
engaged in for profit. They also address the deduction of expenses
related to the hobby. This fact sheet is reprinted below:
Business or Hobby? Answer Has Implications for Deductions
FS-2007-18, April 2007
The Internal Revenue Service
reminds taxpayers to follow appropriate guidelines when
determining whether an activity is a business or a
hobby, an activity not engaged in for profit.
In order to educate taxpayers
regarding their filing obligations, this fact sheet, the
eleventh in a series, explains the rules for determining
if an activity qualifies as a business and what
limitations apply if the activity is not a business.
Incorrect deduction of hobby expenses account for a
portion of the overstated adjustments, deductions,
exemptions and credits that add up to $30 billion per
year in unpaid taxes, according to IRS estimates.
In general, taxpayers may deduct
ordinary and necessary expenses for conducting a trade
or business. An ordinary expense is an expense that is
common and accepted in the taxpayer’s trade or business.
A necessary expense is one that is appropriate for the
business. Generally, an activity qualifies as a business
if it is carried on with the reasonable expectation of
earning a profit.
In order to make this
determination, taxpayers should consider the following
Does the time and effort
put into the activity indicate an intention to
make a profit?
Does the taxpayer depend
on income from the activity?
If there are losses, are
they due to circumstances beyond the taxpayer’s
control or did they occur in the start-up phase
of the business?
Has the taxpayer changed
methods of operation to improve profitability?
Does the taxpayer or
his/her advisors have the knowledge needed to
carry on the activity as a successful business?
Has the taxpayer made a
profit in similar activities in the past?
Does the activity make a
profit in some years?
Can the taxpayer expect to
make a profit in the future from the
appreciation of assets used in the activity?
The IRS presumes that an activity
is carried on for profit if it makes a profit during at
least three of the last five tax years, including the
current year — at least two of the last seven years for
activities that consist primarily of breeding, showing,
training or racing horses.
If an activity is not for profit,
losses from that activity may not be used to offset
other income. An activity produces a loss when related
expenses exceed income. The limit on not-for-profit
losses applies to individuals, partnerships, estates,
trusts, and S corporations. It does not apply to
corporations other than S corporations.
Deductions for hobby activities
are claimed as itemized deductions on Schedule A (Form
1040). These deductions must be taken in the following
order and only to the extent stated in each of three
Deductions that a taxpayer
may take for personal as well as business
activities, such as home mortgage interest and
taxes, may be taken in full.
Deductions that don’t
result in an adjustment to basis, such as
advertising, insurance premiums and wages, may
be taken next, to the extent gross income for
the activity is more than the deductions from
the first category.
Business deductions that
reduce the basis of property, such as
depreciation and amortization, are taken last,
but only to the extent gross income for the
activity is more than the deductions taken in
the first two categories.
The Internal Revenue Code
Section 183 provides a presumption of profit for activities as follows:
If the gross income derived from an activity
for 3 or more of the taxable years in the period of 5 consecutive
taxable years which ends with the taxable year exceeds the
deductions attributable to such activity (determined without regard
to whether or not such activity is engaged in for profit), then,
unless the Secretary establishes to the contrary, such activity
shall be presumed for purposes of this chapter for such taxable year
to be an activity engaged in for profit.
In the case of an activity which consists in
major part of the breeding, training, showing, or racing of horses,
the preceding sentence shall be applied by substituting ''2'' for
''3'' and ''7'' for ''5''.
The rule is clear - show a
profit in 3 out of 5 consecutive years (2 out of 7 for breeding, etc.)
and the IRS must PROVE that you are NOT in the business of making a
profit. If you do NOT meet this test, it does NOT mean you are
presumed to be in the activity for other than a profit motive!
It means that you must rely on other factors (not the presumption)
to persuade the IRS or a Court that you have a profit motive.
Following is a synopsis from a
2005 Tax Court case that
discusses the disallowance of a loss claimed by a dentist for his horse
breeding and showing activity. Pay particular attention to the
factors that the Court considered as evidence of the taxpayer's lack of
Code Section 183—Activities not-for-profit—horse
breeding and showing—proof.
Dentist didn't engage in horse breeding and showing activities for
profit: taxpayer didn't keep separate accounts or business-like records
for activity, didn't operate it comparable to other profitable horse
businesses, didn't try to change her operational methods to correct
14-year loss history, and didn't otherwise show that she carried on
activity in valid business-like manner. Also telling were facts that
taxpayer never gained expertise in horse activity and its peculiar
economics, maintained fulltime dental practice while engaged in
activity, didn't show any real appreciation in value of any of her
horses or horse assets save one, used activity losses to offset
significant income from her dental practice and investments, and drew
personal pleasure from activity. (Elizabeth Giles v. Commissioner,
(2005) TC Memo 2005-28)
Here is a synopsis of a 2007 Tax Court case involving the IRS's
determination that an activity was not engaged in for profit.
You can see what factors the Court considered as relevant in making its determination:
Code Section 183—Activities not-for-profit—horse-boarding—profit
motive—bona fide business.
Sales manager/executive's and wife's for-profit
treatment of loss-generating horse-boarding activity was upheld:
taxpayers conducted activity with actual profit intent as bona fide
business activity within meaning of Code Sec. 183 and Code Sec. 162 .
Although taxpayers admitted that, after following carefully modified
business plan, they realized they would never make profit, such didn't
in itself reflect lack of profit objective and was outweighed by overall
evidence that they had kept meticulous records and accounts, kept
operating in business-like manner until they could sell, and took steps
to mitigate costs and to try and at least break even. Also, taxpayers'
prior experience in owning horses well-qualified them for horse-boarding
business; husband spent substantial time on such despite living hours
from boarding facility; his executive management position salary wasn't
so high as to easily absorb boarding losses; and taxpayers didn't derive
substantial personal pleasure from boarding. (Michael J. Rozzano, Jr.,
et ux. v. Commissioner, (2007) TC Memo 2007-177
Here is a 2012 Court
Case involving horse breeding:
Code Section 183—Activities not-for-profit—horse breeding, training
and sales—profit motive—proof—deductions.
Horse breeding activity engaged in by
homemaker, who held consumer finance degree and real estate license,
and her attorney-husband was activity not engaged in for profit
within meaning of Code Sec. 183 : overall facts and circumstances
showed that instead of holding actual and honest profit objective,
taxpayers engaged in activity as hobby. Factors included that
despite “hemorrhaging losses” and determining that they needed to
acquire their own horse facility rather than pay to board elsewhere
in order to control costs and improve profitability, taxpayers
waited years before even buying land on which to construct their own
facility and otherwise failed to conduct activity in businesslike
manner. Other factors included that activity had sustained losses
which taxpayers used to offset significant income from husband's law
business. Also, allegation that taxpayers' move to new area that was
more hospitable to horse activity showed intent to pursue same as
business was unpersuasive when considering above plus fact that new
area could have been equally welcoming to horse enthusiasts as to
bona fide breeders. (Peter C. Bronson, et ux. v. Commissioner,
(2012) TC Memo 2012-17)
Here is a 2019 Tax Court case in which the
Court determined that the activity was not engaged in for profit.
Donoghue, TC Memo
A married couple's losses from their horse breeding activity were
disallowed. The taxpayers failed to show they had a profit motive
for the activity.
Taxpayers carrying on a
trade or business can deduct ordinary and necessary expenses paid or
incurred while carrying on that trade or business. (Code Sec. 162)
However, if the taxpayer's activity is not engaged in for profit,
then the taxpayer can only deduct expenses up to the income earned
from the activity. (Code Sec. 183) An activity primarily carried on
for sport, as a hobby, or for recreation is not carried on for
profit. (Reg §1.183-2)
The regs under Code Sec.
183 provide a nonexclusive list of nine factors to consider when
evaluating a taxpayer's profit objective. (Reg §1.183-2(b)) These
How the taxpayer carried on the activity;
The expertise of the taxpayer and his or her advisers;
The time and effort spent by the taxpayers in carrying on the
The expectation that assets used in the activity might
The taxpayers' success in similar or dissimilar activities;
The activity's history of income or loss;
The possibility of an eventual substantial profit;
The financial status of the taxpayers; and
The level of personal pleasure or recreation the taxpayer had in
the activity. (Reg. §1.183-2(b))
In this case,
the taxpayers, Mr. and
Mrs. Donoghue, in 1985, started a thoroughbred horse breeding
activity called Marestelle Farm, LLC (Farm). Farm was a "virtual
farm". The Donoghues owned the horses but boarded them at farms and
stables belonging to other people.
While the Donoghues conducted their horse breeding activity
through the Farm, Mr. Donoghue was employed full time as a
programmer. Mrs. Donoghue was disabled and received disability
From 1985 through 2012, the Donoghues owned six horses. However,
they did not breed, race, or sell any of their horses during 2010,
2011 or 2012. The last year the Donoghues raced any of their horses
was 2008. From its inception in 1985 through 2012, their horse
breeding activity incurred expenses totaling $1,008,303, but
realized income totaling only $33,691, resulting in accumulated
losses of $974,612. From 1985 through 2012, their horse breeding
activity never had a profitable year.
The IRS audited the Donoghues' returns for 2010, 2011, and 2012.
In its answer to the Donoghues' Tax Court petition, the IRS
disallowed the claimed losses from their horse breeding activity
because the Donoghues did not engage in that activity for profit.
The Donoghues argued that they operated their horse breeding
activity in a businesslike manner with the intent to make a profit.
Therefore, their losses should be allowed.
Horse breeding activity not engaged in for profit
The Tax Court examined the nine factors in Reg §1.183-2(b).
The Court concluded that the Donoghues did not have an actual and
honest intent to operate their horse breeding activity for profit.
The eight factors weighing in the IRS's favor were:
Manner in which they conducted their horse breeding activity.
During 2010, 2011 and 2012, the Donoghues did not breed, race,
or sell any of their horses. The Tax Court found it was not
reasonable for the Donoghues to claim that they were engaged in
a thoroughbred horse breeding business when it was not engaged
in breeding or racing horses.
Expertise of their advisors.
There was no evidence in the record that the Donoghues acquired,
or even sought, more expert advice about the economics of
profitably running a horse breeding activity than an enthusiast
Time and effort devoted to the activity.
The Donoghues created two spreadsheets during the audit that
listed the time they spent on horse breeding activities for 2010
and 2011. However, the Tax Court found that these spreadsheets
were untrustworthy because they were created from recollection
and the estimated hours reflected were not associated with
actual dates, but with activities performed. Moreover, there was
no contemporaneous documentary evidence corroborating the hours
reported by activity.
Expectation that assets used in the activity may appreciate.
The Donoghues' only assets were their horses since they operated
their horse breeding activity as a "virtual farm". However,
there was no evidence in the record about the value of their
horses. Therefore, the Donoghues failed to show that their
horses would appreciate so much they would come close to
recouping the significant losses they accumulated over the
nearly 30 years of operating their horse breeding activity.
History of the activity's income and losses.
The horse breeding activity did not earn a profit for any year
since its inception in 1985. By 2010, the horse breeding
activity was in its 25th year of operation and,
therefore, long past the start-up phase. Moreover, while the Tax
Court recognized that the horse breeding activity may have been
harmed by the Great Recession, the recession could not account
for the long history of losses that predated the recession.
The horse breeding activity never had a profitable year in its
nearly 30 year history, let alone a year with a substantial
Taxpayer's financial status.
The Donoghues received more than $100,000 of income for each
year at issue. However, the losses generated by the horse
breeding activity reduced their income tax to $538 for 2010 and
zero for 2011 and 2012.
Personal pleasure and recreation.
The possibility for profit was small compared with Mrs.
Donoghue's personal gratification. The Donoghues clearly loved
horses and started their horse breeding activity when Mrs.
Donoghue found her dream horse, but they left the most grueling
aspects of caring for the horses to paid professionals.
Updated - 2019
Taxpayers are often confused by the differences in tax treatment
between businesses that are entered into for profit and those that
are not, commonly referred to as hobbies. Recent tax law changes
have added to the confusion. The differences are:
Businesses Entered Into
for Profit – For businesses entered into for profit,
the profits are taxable, and losses are generally deductible
against other income. The income and expenses are commonly
reported on a Schedule C, and the profit or loss—after
subtracting expenses from the business income—is carried over to
the taxpayer’s 1040 tax return. (An exception to deducting the
business loss may apply if the activity is considered a
“passive” activity, but most Schedule C proprietors actively
participate in their business, so the details of the passive
loss rules aren’t included in this article.)
Hobbies – Hobbies, on the other hand, are not
entered into for profit, and the government currently does not
permit a taxpayer to deduct their hobby expenses but does
require the income from the activity to be declared. (Prior
to the changes included in the Tax Cuts and Jobs Act of 2017,
hobbyists were allowed to deduct expenses up to the amount of
their hobby income as a miscellaneous itemized deduction on
Schedule A. Being able to take this deduction is suspended for
years 2018 through 2025.) Thus, hobby income is reported on
Schedule 1 of their 1040 and no expenses are deductible.
So, what distinguishes a business from a hobby? Let's review the
nine factors the IRS considers when making the decision. No single
factor is decisive, but all must be considered together in
determining whether an activity is for profit. The nine factors are:
(1) Is the activity carried
out in a businesslike manner? Maintenance of complete
and accurate records for the activity is a definite plus for a
taxpayer, as is a business plan that formally lays out the
taxpayer’s goals and describes how the taxpayer realistically
expects to meet those expectations.
(2) How much time and effort does the taxpayer spend on
the activity? The IRS looks favorably at substantial
amounts of time spent on the activity, especially if the
activity has no great recreational aspects. Full-time work in
another activity is not always a detriment if a taxpayer can
show that the activity is regular; time spent by a qualified
person hired by the taxpayer can also count in the taxpayer’s
(3) Does the taxpayer depend on the activity as a source
of income? This test is easiest to meet when a taxpayer
has little income or capital from other sources (i.e., the
taxpayer could not afford to have this operation fail).
(4) Are losses from the activity the result of sources
beyond the taxpayer’s control? Losses from unforeseen
circumstances like drought, disease, and fire are legitimate
reasons for not making a profit. The extent of the losses during
the start-up phase of a business also needs to be looked at in
the context of the kind of activity involved.
(5) Has the taxpayer changed business methods in an
attempt to improve profitability? The taxpayer’s efforts
to turn the activity into a profit-making venture should be
(6) What is the taxpayer’s expertise in the field?
Extensive study of this field’s accepted business, economic, and
scientific practices by the taxpayer before entering into the
activity is a good sign that profit intent exists.
(7) What success has the taxpayer had in similar
operations? Documentation on how the taxpayer turned a
similar operation into a profit-making venture in the past is
(8) What is the possibility of profit? Even though
losses might be shown for several years, the taxpayer should try
to show that there is realistic hope of a good profit.
(9) Will there be a possibility of profit from asset
appreciation? Although profit may not be derived from an
activity’s current operations, asset appreciation could mean
that the activity will realize a large profit when the assets
are disposed of in the future. However, the appreciation
argument may mean nothing without the taxpayer’s positive action
to make the activity profitable in the present.
There is a presumption that a taxpayer has a profit motive if an
activity shows a profit for any three or more years within a period
of five consecutive years. However, the period is two out of seven
consecutive years if the activity involves breeding, training,
showing, or racing horses.