J.K. Lasser's Small Business Taxes 2013: Your Complete Guide to a Better Bottom Line

Hobby Losses

If your unincorporated business sustains losses year after year, you may not be able to deduct the losses in excess of your business income unless you can show that you have undertaken the business in order to make a profit. This limitation on losses is called the hobby loss rule, because it is designed to prevent individuals who collect coins and stamps, breed dogs or cats, or carry on other hobby activities from deducting what the tax law views as personal expenses. Any activity you do mainly for recreation, sport, or personal enjoyment is particularly suspect.

But the hobby loss rule is not limited to these types of activities. It can apply to any activity—even investment activities intended to produce only tax losses for investors. In fact, the IRS even tried to apply the hobby loss rule to a young attorney just starting her practice. The IRS argued that the losses she sustained were not deductible because of the hobby loss rule. The attorney was able to show a profit motive (proof of a profit motive is explained later) and she was allowed to deduct her losses.

The hobby loss rule applies to individuals (including partners and LLC members) and S corporations. It does not apply to C corporations. For partnerships, LLCs, and S corporations whose business losses pass through to owners, the determination of whether there is a profit motive is made at the business level rather than at the owner level. In other words, the business itself must have a reasonable expectation ...