Losing Money - Some Hobby

When running a business, it's normal and healthy to try to make money.  That's the point.  It's also normal and healthy to try to lower your taxes.  But when the only way your business makes money is because the losses cut your taxes, things can go awry.

The tax law's "hobby loss" rules disallow deductions from "activities not engaged in for profit."  The preferred way to avoid problems with these rules, of course, is to make money, but the tax law recognizes that profits don't always happen.  But if you never make money, the IRS gets suspicious.

Some activities are "red flags" that invite hobby loss trouble.  Naturally, these tend to be things that people do for fun.   Raising horses, racing, and golfing are activities that the IRS has challenged as being "activities not arranged for profit."

Another "red flag" is a pattern of losses continuing over a period of many years.  If you continue to lose money over time, the IRS naturally suspects that you aren't really running a business, but are instead trying to deduct personal expenses as business expenses. 

Amway distributors have had their share of trouble with the hobby loss rules. A quick search of a tax law database shows over 40 cases where Amway distributors have lost court fights with the IRS. The earnings pattern for an Amway distributor in a recent Illinois case illustrates how to invite hobby loss trouble:

   Year       Income             Expenses      Net Losses
    1996         $10            ($ 1,625)       ($ 1,615)
    1997         357             (13,177)        (12,820)
    1998         625             (17,504)        (16,879)
    1999       1,450             (17,384)        (15,934)
    2000       3,235             (23,001)        (19,766)
                _____             _______       _______ 
    Total       5,677             (72,691)       (67,014)

One commentator cites three typical problems for Amway distributors who have lost in court: "a sustained series of losses; the use of Amway losses to offset other income; and a failure to conduct the distributorship in a businesslike manner."

So how do you ward off an IRS hobby loss challenge?  The tax law looks at a number of factors, including whether the taxpayer has a credible business plan for turning a profit; how carefully the taxpayer keeps records; and whether the taxpayer changes tactics to try to reverse losses.   These really all come down to: do you run your business like a business?

The moral? If the activity loses money over a period of years, and the losses offset income from another full-time job, there's tax trouble brewing.