Musicians, Horse Farms, and Amway
Is it a hobby or a business? And how that affects your clients’ returns.

You may have clients with “side” businesses that, while not their main source of income, provide them a combination of pleasure and profit potential. Well . . . maybe their businesses have future profit potential, and that potential might be met WAY in the future. Sure it’s generating losses now, but one day, it’s going to make me rich. 
Until that fateful day, they will draw additional IRS scrutiny if they continually show a loss year after year while raising horses, playing music, or operating any side business, especially with the IRS’ new initiative to close the tax gap. 
The IRS will disallow losses claimed if they deem the business to be a hobby vs. a real business. Here are the basics you should know.

Is it a business or just for fun?
The IRS will generally assume a business is not a hobby if it showed a taxable profit in three of the previous five tax years (two out of seven years for horse breeding and other horse-related activities). If your client is questioned before this time frame has elapsed, you can file Form 5213 within 60 days of receiving an IRS notice to delay the determination until the end of the fourth tax year (sixth year for horses). Be aware, however, that Form 5213 also extends the statute of limitations for that activity.
Just because a business isn’t showing a profit does not preclude the loss from being deductible. It simply becomes a little trickier to prove the profit motive.
The IRS has provided guidance on what factors it will use to determine whether a business with a taxable loss is actually a for-profit venture:
• 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?

Some practical suggestions
Ask plenty of questions. Dealing with a client who insists he should be able to write off the expenses of his hobby can be difficult. If your client considers his garage band a serious business, suggest that he begin treating it like one. If you provide consulting services, give him a letter with his tax return making suggestions on how he can make his business profitable. 
You might also advise your client to:
• Open a checking account for the business separate from his personal account.
• Take a class or attend a seminar on how to make his business profitable.
• Document an annual plan that includes goals for the year to make the business profitable.
• Set up a budget for the business and/or a projection showing profitability in future years.

Disallowed hobby losses – take a different approach
In instances where the IRS disallows losses, or where you determine a client’s venture is a hobby and not a business, all may not be lost. Deductions for hobby activities can be 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 categories:
• Deductions that a taxpayer may take for personal and 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.

From October 2007

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