Business or Hobby? How to Avoid the Dreaded IRS “Hobby” Classification

Jan 9, 2023

Side businesses have become increasingly popular among Americans over the last several years.  With the ability to work remotely and the forced lockdowns caused by the COVID-19 pandemic, this trend has seen significant growth since 2020.  For some individuals, this extra source of income is necessary to make ends meet, while others engage in these activities simply for enjoyment, and making extra money is just an added benefit.

If a taxpayer runs a legitimate business, they can report their income and loss as incurred without questions or contention from the IRS.  However, if their activity is deemed to be a hobby, they must report the income, but can only deduct expenses up to the amount of income recognized.  However, the ability to deduct hobby losses/expenses was eliminated with the passage of the 2017 Tax Cuts and Jobs Act because those items were considered Miscellaneous Itemized deductions. Therefore, taxpayers deemed to have a hobby are stuck recognizing the income with no way to deduct the related expenses.

This recent rule change makes it more important than ever to avoid the hobby classification; this article will outline the necessary steps taxpayers must take to avoid being classified as a hobby instead of a legitimate business.

Cash (Profit) is King

The easiest way to contest an IRS assessment that your side business is a hobby is to turn a profit.  There is a safe harbor method available that states taxpayers who show a profit in at least three of the last five years (including the year in question). If your business involves horse racing, breeding, or showing, the safe harbor is two of the last seven years. If this safe harbor is met, the burden of proof to demonstrate your business is a hobby shifts to the IRS. The IRS can still contest a taxpayer’s business classification if the safe harbor is met, but it’s an uphill battle. Continued work by the IRS is most common in cases where the profitable years showed marginal profit and the loss years contained much larger amounts.

Example of the Use of the Safe Harbor Method

The “test” period for the safe harbor does not begin to run until the first year an activity shows a profit.  For example, suppose a taxpayer starts a new business and incurs losses in years 1, 3, and 6, while turning a profit in years 2, 4, and 5. When applying the five-year safe harbor test, the testing period cannot start until year 2, the first profitable year. This means the safe harbor period is the five-year period for years 2-6. Also, the safe harbor only applies to years 5 and 6 because year 5 is the third year a profit was made in the activity, which means the loss in year 6 is covered under the safe harbor rules. The losses in years 1 and 3 are not covered so if this taxpayer is examined, the IRS would likely attempt to disallow the losses for both of those years under the hobby loss rules. Despite failing the safe harbor test, a taxpayer could still fight the hobby classification under a facts and circumstances test.

Other Facts & Circumstances to Aid in Business Classification

Even if a taxpayer fails the safe harbor test for a few years, all is not lost. There are several additional steps a taxpayer can take to show they are running a business rather than engaging in a hobby.

  • Keep accurate books and records. Maintain a separate bank account for the activity and track income and expenses. Also, document your attempts to improve profitability as you progress.
  • Leverage your expertise. The more you know about your business and product or service, the more likely you are to be able to operate efficiently and profit from your efforts. Document the time spent studying your business and working to improve. Also, track any time and expense to consult with industry experts in an effort to broaden your knowledge of your business.
  • Track your time spent in the business. Maintain a log detailing the number of hours spent working on your business. The more time spent in the business, the more likely you will be successful in avoiding the hobby classification.
  • Your personal financial status. The IRS will examine your net worth and other income sources when contesting a business classification. If you have income from other sources that more than offset your losses in this activity, the IRS will push harder to classify the activity as a hobby.
  • Your prior track record. If you have been successful in the past running small businesses, the IRS will take that into consideration. If you can show past experience in running your own business and making consistent profits, that will help maintain your business classification.
  • The element of pleasure or recreation involved in the activity. If the activity in question contains a mix of both business and pleasure, the IRS will key on that and will likely label the whole activity as a hobby.

Regarding the list above, many of these elements can be controlled by the taxpayer in full or to an extent. The first three in the list are key to proving legitimate business intent. Maintaining good records, tracking your time spent in the business, and working to improve your industry knowledge are key steps to contesting an IRS assessment of your activity as a hobby.


The hobby loss rules contain many pitfalls for the unwary taxpayer, and the changes the in rules have tilted the playing field in favor of the IRS. With a solid business plan, good records, and time and expertise spent in the activity, you can work to combat a hobby assessment and work to classify your activity as a business. An experienced CPA can work with you to put all the necessary elements together to maintain business classification and enjoy the related tax benefits.