Hobby Loss Presumptive Rule. Rachel Schutz is a high school English teacher. In her
spare time, she likes to make her own body lotion, lip-gloss, and bath and shower gel. She
uses the bath products herself and gives them to her friends and relatives as gifts. In 2005,
Rachel started attending arts and crafts festivals to sell her products three or four times a
year, and she hands out her business card so her customers can buy directly from her by
phone or email. In 2005, Rachel reported a net loss of $375 from the activity. In 2006, she
reported a loss of $460. Rachel is audited for the year 2006, and the agent disallows the
$460 loss. Rachel is pretty sure she will make a profit on her sales in 2007, and she assumes she will continue to make a profit after 2007. Rachel is not sure that she can
prove that her activity is not a hobby right now. What can she do to avoid proving that
her loss is not a hobby loss?
First, the term "hobby loss" is a misnomer. The actual name used in the Internal Revenue Code is "an activity not entered into for profit." The fact is, she needs to prove that she has a profit motive. In general, she satisfies that presumption by earning a profit in 3 of any 5 years during which she conducts the activity. If she cannot earn profits in 3 years of a 5-year period, she can still prove that she has a profit motive using the following nine factors found in Treas. Reg 1.183-16:
1. The manner in which the taxpayer carries on the activity: She actively pursues new ...
In this solution, I discuss the factors in favor and against a taxpayer wishing to avail herself of tax deductions for business losses when the activity she has entered into may be considered an "activity not entered into for profit" (i.e., a hobby loss).