What is profit motive?
People have different motives for their activities. Some activities are purely for fun, some are to help others, and some are motivated by profit. Having a profit motive means that you intend to earn more in revenue from the activity than you incur in expenses. It doesn’t mean you’ll necessarily earn a profit. It just means that that’s your intent.
Hobby or business?
One of the unexpected consequences of the COVID-19 pandemic is people discovering, or rediscovering, hobbies and other fun activities that made quarantining at home for long periods of time more palatable. And some hobbyists have even made money from these activities. But does that mean the activity is no longer a hobby but is instead a business?
It's important to understand the difference between a business and a hobby. There are very different tax consequences. You have to report income earned from both a business and a hobby. A business can deduct its ordinary and necessary expenses and take a loss if it isn't profitable. But if your activity is classified as a hobby, you can't deduct any hobby-related expenses. This has been the case since the Tax Cuts and Jobs Act eliminated miscellaneous itemized deductions beginning in 2018.
So what’s the difference between a hobby and a business? According to the IRS, a business operates to make a profit. People engage in a hobby for sport or recreation, not to make a profit. So motive is important.
The nine-factor test to determine profit motive
In determining whether you are carrying on an activity for profit, several factors are taken into account by the IRS. No one factor alone is determinative. Among the factors the IRS says you should consider are whether:
- You carry on the activity in a businesslike manner
- The time and effort you put into the activity indicate you intend to make it profitable
- You depend on the income for your livelihood
- Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business)
- You change your methods of operation in an attempt to improve profitability
- You (or your advisors) have the knowledge needed to carry on the activity as a successful business
- You were successful in making a profit in similar activities in the past
- The activity makes a profit in some years
- You can expect to make a future profit from the appreciation of the assets used in the activity
Three profitable years create presumption of profit motive
An activity is presumed to be for profit by the IRS if it produced a profit in at least three of the last five tax years. (Activities that consist primarily of breeding, training, showing, or racing horses are presumed carried on for profit if they produced a profit in at least two of the last seven tax years.) The activity must be substantially the same for each year within this period.
If your activity passes the three-years-of-profit test, the IRS will presume it is carried on for profit and you can take your business deductions from the activity, including for the years that you had a loss.
Electing to postpose examination of profitability
If you are starting an activity and do not have three years showing a profit, you can elect to have the IRS wait until you have five years of experience before it questions whether your activity is engaged in for a profit. Accordingly, the IRS will not restrict your deductions, and you will gain time to earn a profit in the required number of years. To make this election, you must file Form 5213 with the IRS within three years after the due date of your tax return for the year in which you first carried on the activity, or, if earlier, within 60 days after receiving written notice from the IRS proposing to disallow deductions attributable to the activity.
If you aren’t sure if the profit you made from an activity borne out of the pandemic would be considered income from a business or a hobby, you may want to consult with a tax professional.
Related resources:
Double taxation: What is it and why should businesses care?