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How Does the IRS Hobby Loss Audit Work?

How Does the IRS Hobby Loss Audit Work?

For many entrepreneurs, the idea of getting a second hustle seems efficient. Most people convert their hobbies into a second business. As an entrepreneur, you may have an idea of the immense benefits behind putting off business expenses concerning tax payments. Converting your hobby into a business offers much returns, getting paid for doing what you love and staying tax-free using the other business expenses.

If this is your case, you need to understand how the IRS treats hobbies and how they audit them. Any hustle that is not in the business of making a profit is classified as a "hobby" by the IRS. Businesses, however, are declared to post profits regularly. After making the necessary calculations, including subtracting gross from net revenues, any loss will be tagged as a taxable loss which can be used to offset other business income. 

For instance, consider someone who has a hobby of making furniture and has decided to start selling them. Suppose your first year of business posts a loss of $2000. And, after the IRS audit, your hustle is classified as a business. In that case, you can convert the loss to cover other expenses, e.g., salaries, gas, etc. If classified as a hobby, you can't use the loss as any other expense.


How IRS carries out the Hobby Loss Audit

There are nine distinct requirements the IRS looks out for to classify your hustle as either a business or a hobby. They include:

  •  Whether you operate the hustle as a business with books, checks, and balance sheets.   

  • The motive behind the hustle.

  • Human capital including effort and time to make the hustle profitable.

  • How much do you rely on it as a source of livelihood?

  • Losses beyond human control.

  • The business experience you and your advisors possess to carry out the business. 

  • If you have ever posted a profit in any given business calendar year. 

  • If it has profited you, how much was the profit? 

  • If the future projections show a profit upon the sale of assets.

These criteria are Uncle Sam’s benchmark marks in determining whether it is a hobby or a full-fledged business. When the IRS is about to carry out an audit, they use a rule: "An activity will be presumed for profit if there is a profit in at least three of the past five years of paying tax, including the present year (or at least two of the last seven years for activities that consist primarily of showing, breeding, training or horses in races."

So, if you have the hustle of making furniture that you do in your spare time, you have decided to profit from it. The IRS officials will go over the past five years to determine if at least you made a profit in three out of the five. 

If you made a profit in any three of the five years, your hustle will be considered a business and pass the IRS hobby loss rule. You can now use the loss from the two years to cover other income, which should be taxed ideally. 

If your hustle posts a loss in three of the five years, it has failed the IRS Hobby loss rule. In this case, you'll have to find a way to pay the taxes of the other taxable income you have incurred. 


How to pass the IRS Hobby Loss Audit?

There's only one best way to acing this audit: treat your hustle as a respectable business. That means you'll need records, books, a budget, and financial advisors and partners. Keep precise records so you can present them to the IRS on their next audit of your hustle. 


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