C corporations, S corporations, limited liability companies, limited partnerships, professional corporations, and nonprofit organizations all may be questioned by the IRS regarding profits, losses, and even whether the activity is a business or a hobby. For an activity to be considered a business, it must be engaged in for profit. If the activity is not engaged in for profit, it is subject to the hobby loss rules in Sec. 183. Whether an activity is a business or a hobby is important because under the hobby loss rules, the deductible expenses of a hobby are limited to the amount of income it generates and are further subject to a floor of 2% of adjusted gross income (AGI) as a miscellaneous itemized deduction.
Regs. Sec. 1.183-2(b) lists nine factors for determining whether a taxpayer engages in an activity for profit. However, these factors are not exhaustive, and each must be weighed in the context of the activity.
The first factor is how a taxpayer carries on the activity. A tax preparer would first want to look for how the taxpayer handles the entity, ensuring that he or she is conducting all activity in a businesslike manner. The taxpayer can establish this by maintaining separate personal and business bank accounts, keeping records and books, and acting like similar profitable, operational entities.
The second factor is the expertise of the taxpayer. A business operator should have extensive knowledge of his or her profession or activity, showing that he or she has studied accepted business methods and sought advice from experts.
The third factor is whether the taxpayer expends substantial time and effort in carrying out the activity.
Example: J manages a janitorial service, and his prime contract is with a fast-food chain. J also works three days a week teaching at a local university, and can clean the restaurants only late in the evening after closing or early in the morning before opening. This causes him to devote much of his personal time and effort to the cleaning. Dedicating personal time to such an activity indicates that a taxpayer entered into the activity, or continued the activity, with the actual and honest objective of making a profit.
The fourth factor is an expectation that assets used in an activity, such as land, may appreciate in value. Regs. Sec. 1.183-2(b)(4) says such appreciation may be considered in lieu of current profits: "[E]ven if no profit from current operations is derived, an overall profit will result...