Each year, millions of business owners claim the coveted tax deduction for business expenses, and each year, many of the deductions claimed are ultimately rejected. Returns are rejected when business owners fail to demonstrate to the IRS that their business activity has a profit-making motive.
This normally occurs when a business claims a net loss for a number of years and has not reported on any prior years' tax returns that the business had earned a profit.
It may seem incredibly obvious that a business needs to earn money, but some taxpayers claim the deduction for the sole purpose of generating losses and lowering their taxable income. This, my friend, is an IRS no-no!
To claim the tax deduction for business expenses, the taxpayer must first have a business. Then, to prove to the IRS that the business exists, the taxpayer must prove that the economic activity the taxpayer is engaged in has a profit-making motive (even if the business has experienced a loss in prior years).
How to demonstrate a profit-making motive
For the IRS to deem your activity business-worthy, you must demonstrate a profit-making motive and have profited in three of the last five years. Unfortunately, if you cannot demonstrate a profit-making motive, the IRS will downgrade your activity to a hobby. To prevent this from happening, learn what you will need to show the IRS to prove your profit-making motive.
The IRS will examine the following factors to determine whether your activity is profit-motivated:
- Is the activity carried out in a businesslike manner?
- Does the taxpayer put time and effort into the activity?
- Do the taxpayer's activities indicate an intent to make a profit?
- Does the taxpayer depend on the activity for their livelihood?
- If the taxpayer has losses, are they due to circumstances beyond the taxpayer's control or start-up costs?
- Has the taxpayer made any changes to improve their chances of making a profit?
- Does the taxpayer have the knowledge and skill to conduct a successful business?
- Has the taxpayer earned a profit from a similar activity?
- Has the taxpayer profited from the activity in any year?
Note: This list is not all-inclusive.
It would be problematic for the IRS to downgrade your activity to a mere hobby, as hobby expenses are no longer deductible. This deduction was part of the miscellaneous itemized deductions the Tax Cuts and Jobs Act (TCJA) eliminated from 2018 through 2025.
On the brink of the IRS declaring your business a hobby?
If you are on the brink of the IRS declaring your business activity a hobby -- do not panic. The IRS has a provision for you. If you were unable to make a profit in three of the last five years, you can file IRS form 5213 to postpone the determination of whether an activity is being engaged in for profit.
The IRS can give filers of form 5213 more time to prove a motive is profit-driven. If you plan to file IRS form 5213, you must file on the earlier of the following two dates: (1) Three years after the due date of the tax return filed the year in which the business deductions were claimed or (2) within 60 days of receiving written notice from the IRS proposing to disallow deductions attributable to the activity.
Note: By filing IRS form 5213, you automatically extend the time the IRS can audit you.
The Millionacres bottom line
If you are unable to demonstrate to the IRS that you have a profit-making motive, do not let your sweat equity and your dream of becoming a successful business owner go to waste. Contact your tax advisor about filing IRS form 5213 to postpone the determination of a for-profit motive.