The IRS Nine-Factor Test: Assessing Your Activity Under the Hobby Loss Rules

IRS Nine Factor Test

Many individuals are engaged in hobby activities that also serve as a source of income. For tax compliance, you need to answer one crucial question: does the income you generate from this activity count as an official business or are you simply seen as monetizing a hobby? The distinction is key to understanding the scope of your tax deductions, because, if the IRS doesn’t deem your income as derived from business activity, you cannot submit expense deductions for it. To determine the nature of your income generating activity, the IRS employs a “Nine-Factor Test”.

In this article, we delve into the IRS’s nine-factor criterion to help you understand its implications on your tax situation. Whether you’re transforming a hobby into a side hustle or a startup navigating your business journey, these insights help to ensure your compliance with tax laws.

The nine factors

The IRS considers a hobby to be any activity that a person pursues without the intention of making a profit. The nine-factor test considers various factors, including your expertise and the effort you make to generate sales, to determine whether your business operates for profit. Therefore, it is important to correctly categorize your activity. These factors form part of the overall assessment of whether an activity is a business or a hobby. 

  1. How you conduct your business activity. A systematic approach suggests a business intent. Having a written business plan with systemic financial tracking would indicate business intent, for example. 
  2. Time and effort devoted to the activity. Being actively involved in an income-generating endeavor also supports a business classification, as this shows intent to make it profitable. 
  3. Financial status of the taxpayer. The IRS considers whether you rely on the income for your livelihood. If your losses are offsetting other income, it could suggest a hobby, particularly if you have substantial other income.
  4. History of income or losses. Making substantial profits suggests a business, while consistent losses could imply a hobby. 
  5. Profit monitoring. Even if the activity generally incurs losses, occasional significant profits – and attempts to boost these profits – validate business intent. 
  6. Stakeholder expertise. If you or your advisors have the knowledge needed to carry out the activity as a successful business it also validates business intent to the IRS.
  7. Success in similar activities. A history of turning similar pursuits into profitable ventures can indicate that you have a business-oriented mindset, rather than engaging in a hobby.
  8. Expectation of asset appreciation. If part of the activity’s profit potential comes from the appreciation of assets (like real estate, for example), you can view it as a business. This factor considers the long-term financial strategy behind the activity. 
  9. Elements of personal enjoyment or recreation. If the activity also serves as a source of personal pleasure or recreation, the IRS may lean towards classifying it as a hobby. 

Impact on tax reporting

The way you categorize an activity — as a business or a hobby — significantly impacts tax reporting and liability.

  • For businesses: There are a wide range of expenses that can be deducted from income to reduce tax liability. These include costs incurred for advertising, home office expenses, and travel. You can also use losses from business activities to offset other income, further reducing taxable income.
  • For business activities deemed as hobbies: The IRS requires you to report the earnings as additional income on your personal tax return and restricts deductions to the amount of income you generate from the hobby. You must take any deductions from a hobby as itemized deductions, which limits their tax benefit. Similarly, you cannot use losses from a hobby to offset other income, which can significantly increase overall tax liability.

Ensuring the correct classification is crucial because misclassifying business activity can lead to audits and penalties if the IRS determines you have wrongly claimed deductions or incorrectly reported losses.

Proper record-keeping

When it comes to substantiating business activity or showcasing your income as a hobby you need thorough records. The following evidence will justify business intent.

  • Detailed records of business plans, financial transactions, annual financial statements, and tax returns. You can typically automate this with reliable accounting software.
  • Training certificates.
  • Activity logs of hours worked and tasks performed to verify the time you devote to business activity. You can typically automate this with accounting software tools like QuickBooks.
  • Asset appreciation appraisals, market analysis reports, and investment plans. 
  • Records of past business ventures, such as profit and loss statements.

While this may seem laborious, organizing these records not only supports your tax position but also streamlines any audits or inquiries from the IRS.

Get help from an expert

Partnering with a Fusion CPA can help you in many ways in this regard. 

  • We have expert knowledge of tax laws and can help interpret the nuances of each factor in the IRS test.
  • We ensure that your activity is correctly classified and that you’re maximizing your tax benefits.
  • Our CPAs can implement accounting tools and software for accurate record-keeping. 
  • We strategize to fully leverage all potential deductions.

It is our goal to put money in your pocket and help you stay compliant. Contact us for assistance. 

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This blog article is not intended to be the rendering of legal, accounting, tax advice, or other professional services. We base articles on current or proposed tax rules at the time of writing and do not update older posts for tax rule changes. We expressly disclaim all liability regarding actions taken or not taken based on the contents of this blog as well as the use or interpretation of this information. Information provided on this website is not all-inclusive and such information should not be relied upon as being all-inclusive.