If you claim business losses too many years in a row, the IRS could designate your business as a “hobby” for tax purposes. This basically means you aren’t allowed to take anymore losses.
The IRS describes a hobby as a money-generating activity that you aren’t trying to make a profit off of. The profit motivation is a key factor in determining whether something counts as a business or not. If you report too many consecutive losses, the IRS assumes you’re not trying to make money.
General rule of thumb: Try to report a profit for three of the last five years you were in business. This is referred to as a “Safe Harbor Rule.” If you can demonstrate you had a profit, the IRS automatically assumes you’re a business. If you go five or more years reporting losses, you aren’t automatically going to be labeled a hobby, but the IRS will have grounds to investigate.
There are a number of things the IRS will consider if you get audited, such as your time involvement in the activity, your professional background, and the nature of the industry you’re working in
Taxpayers have the right to challenge the IRS in tax court if they decide their business has been unfairly labeled.
What happens if the IRS decides you’re a hobby? First, you likely be on the hook for back taxes and penalties if the IRS determines your prior business losses were not legitimate.
Going forward, your hobby will still be reported on a Schedule C, but you’ll only be allowed to claim business expenses to the extent that you have business income (meaning you aren’t allowed to generate a loss).
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Sarah is a staff writer at Keeper Tax and has her Enrolled Agent license with the IRS. Her work has been featured in Business Insider, Money Under 30, Best Life, GOBankingRates, and Shopify. She has nearly a decade of public accounting experience, and has worked with clients in a wide range of industries, including oil and gas, manufacturing, real estate, wholesale and retail, finance, and ecommerce. Sarah has extensive experience offering strategic tax planning at the state and federal level. During her time in industry, she handled tax returns for C Corps, S corps, partnerships, nonprofits, and sole proprietorships. Sarah is a member of the National Association of Enrolled Agents (NAEA) and maintains her continuing education requirements by completing over 30 hours of tax training every year. In her spare time, she is a devoted cat mom and enjoys hiking, baking, and overwatering her houseplants.