Business Entities and Considerations · Business entities

Hobby versus business determination and loss limitations

The hobby loss rules are usually taught as a rule about deductions, and since 2018 they have not been that. An individual whose activity is not engaged in for profit reports the gross income and deducts nothing against it — not because IRC § 183 says so, but because the deductions IRC § 183(b)(2) would allow are miscellaneous itemized deductions, disallowed by a different section entirely. The 2025 Act made that disallowance permanent. The practical question is no longer how much of the expenses survive; it is whether the activity is a business at all, because the answer decides between deducting everything under the ordinary rules and deducting nothing.

The rule

The disallowance. where an activity engaged in by an individual or an S corporation is not engaged in for profit, no deduction attributable to it is allowed except as IRC § 183 itself provides; an activity not engaged in for profit means any activity other than one for which deductions are allowable under IRC § 162 or under § 212(1) or (2) (IRC § 183(a), (c))^TY2026

What is nonetheless allowed. the deductions allowed are those that would be allowable without regard to profit motive, plus an amount equal to the deductions that would be allowable only if the activity were engaged in for profit — but only to the extent the gross income from the activity exceeds the first category (IRC § 183(b))^TY2026

In what order. the three tiers run in order: deductions allowable irrespective of profit motive, to their full extent; then deductions that do not adjust the basis of property, to the extent gross income exceeds the first tier; then deductions that do adjust basis, to the extent gross income exceeds the first two (Reg. § 1.183-1(b)(1))^TY2026

And why the second tier now does nothing. no miscellaneous itemized deduction is allowed for any taxable year beginning after 31 December 2017. Pub. L. 119-21 § 70110(a) struck the words that had ended the suspension before 1 January 2026 and rewrote the heading accordingly, and § 70110(b)(2) redesignated the provision as IRC § 67(h) — so the suspension is permanent, and the IRC § 183(b)(2) tier of hobby deductions is unavailable to an individual for any year (IRC § 67(h))^TY2026

The presumption. gross income exceeding deductions in 3 or more of the 5 consecutive taxable years ending with the current year, or 2 of 7 where the activity consists in major part of breeding, training, showing or racing horses^TY2026

Postponing the test. a taxpayer may elect that the determination whether the presumption applies not be made before the close of the fourth taxable year following the year in which the taxpayer first engages in the activity — the sixth taxable year for a horse activity — in which case the presumption applies to each year of the 5-year or 7-year period beginning with that first year (IRC § 183(e)(1), (2))^TY2026

The factors — the first three. the manner in which the taxpayer carries on the activity, including whether it is businesslike and whether complete and accurate books are kept; the expertise of the taxpayer or their advisers, and whether the activity is in fact carried on in accordance with accepted practice; and the time and effort expended, particularly where the activity lacks substantial personal or recreational aspects (Reg. § 1.183-2(b)(1) to (3))^TY2026

The next three. the expectation that assets used in the activity may appreciate, profit for this purpose including appreciation in land; the success of the taxpayer in carrying on other activities, similar or dissimilar, and in turning them profitable; and the history of income or losses, start-up losses counting for little but unexplained continuing losses counting against, while losses from drought, disease, fire, theft, weather, involuntary conversions or depressed markets do not (Reg. § 1.183-2(b)(4) to (6))^TY2026

The last three. the amount of any occasional profits, judged against the losses and against the taxpayer investment; the financial status of the taxpayer, substantial income from other sources counting against a profit motive especially where the losses generate substantial tax benefits and personal elements are present; and elements of personal pleasure or recreation (Reg. § 1.183-2(b)(7) to (9))^TY2026

How they are weighed. all facts and circumstances are taken into account, no one factor is determinative, the listed factors are not exhaustive, and the determination is not made by counting whether more factors point one way than the other (Reg. § 1.183-2(b))^TY2026

Current figures

How it works in practice

Begin with what IRC § 183(c) says, because it is a definition by exclusion. An activity is “not engaged in for profit” if deductions are not allowable for it under IRC § 162 or § 212. The question is therefore not whether the activity meets some abstract standard of seriousness, but whether it is a trade or business, or an activity for the production of income, under the sections that ordinarily govern those things. IRC § 183 is a consequence, not a test.

The test that does the work is the profit objective, and the regulation’s nine factors are how it is established. The regulation is unusually explicit that they are not a scorecard: all facts and circumstances count, the list is not exhaustive, no factor is determinative, and counting factors on each side is expressly not the method. In practice the first factor — businesslike conduct, complete and accurate books, a willingness to abandon methods that are not working — carries more weight than its position suggests, because it is the one a taxpayer can still improve.

Two of the factors are traps for the sympathetic client. The financial status factor counts against a profit motive where the taxpayer has substantial income from other sources and the losses generate substantial tax benefits (Reg. § 1.183-2(b)(8)), and the personal pleasure factor counts against where recreational elements are present. A well-paid professional who breeds horses at a loss has two factors running against them before anyone looks at the books, which is precisely why the statute gives horse activities their own longer presumption window.

The presumption in IRC § 183(d) is a presumption and not a safe harbour, and it is worth being exact about what it does. Three profitable years out of five shifts the burden: the activity is presumed to be for profit unless the Secretary establishes the contrary (IRC § 183(d)). It does not conclude the matter, and failing the test proves nothing at all — an activity that has never had a profitable year may still be a business, and many genuinely are during a long start-up.

The IRC § 183(e) election is useful and under-used. A taxpayer beginning a new activity may postpone the determination until the close of the fourth year following the first — the sixth for a horse activity — so the presumption can be applied once there is enough history to apply it to. The cost is that the election extends the assessment period for the years concerned, which is why it is not automatic.

Now the part that changes the advice. IRC § 183(b)(2) allows the profit-motive deductions up to the excess of gross income over the first tier, and for an individual those are miscellaneous itemized deductions. IRC § 67(h) disallows every miscellaneous itemized deduction for any year beginning after 2017, and the 2025 Act struck the words that would have ended the suspension after 2025. A hobbyist therefore reports gross receipts and deducts nothing of the activity’s own expenses: no netting, no offset by way of IRC § 183(b)(2), no carryforward. The stakes on the business-or-hobby question are total rather than partial, which is the opposite of how the topic was taught for fifty years.

Scenarios

How this has changed

The practical shape of this topic changed twice, in 2018 and again in 2025, and neither change touched IRC § 183 itself.

Until 2018 a hobbyist could deduct the activity’s expenses up to its gross income, as a miscellaneous itemized deduction subject to the two-percent floor — hence the familiar advice that a hobby “can break even but cannot show a loss”. The 2017 Act suspended miscellaneous itemized deductions for 2018 through 2025, making the second tier of IRC § 183(b) a dead letter for individuals, and the advice became that a hobby cannot even break even.

Practitioners have spent seven years treating that as temporary, because it had a stated end date. Pub. L. 119-21 § 70110(a) removed it: the suspension now applies to any taxable year beginning after 31 December 2017, with no terminal date, and § 70110(b)(2) redesignated the provision from IRC § 67(g) to § 67(h) — which matters because a cite to ”§ 67(g)” now points at the new educator expenses definition rather than at the suspension. Any material citing § 67(g) for the suspension is citing the wrong subsection of the right section.

IRC § 183 itself has not been amended. Its second tier remains in the Code, fully operative in its own terms, and disabled entirely by a provision three hundred sections away. That is worth stating plainly because reading IRC § 183 alone gives exactly the wrong answer.

Exam focus

Two shapes recur. The first gives a taxpayer with an activity, some years of results, and asks whether the presumption applies: count profitable years within the five consecutive years ending with the year in question, and check whether the activity is a horse activity, where the test is two of seven. Remember that the presumption is only ever a burden-shifter.

The second gives facts pointing both ways and asks whether the activity is engaged in for profit. Work the factors, and expect the answer to turn on businesslike conduct and records, on whether the loss history is a start-up or an unexplained continuation, and on whether there are recreational elements combined with substantial other income.

Where a question asks what may be deducted by a taxpayer whose activity is not engaged in for profit, the answer for a current year is the first tier only — the deductions allowable irrespective of profit motive. An option offering “expenses up to the amount of gross income” is testing whether you know the second tier is unavailable.

Check yourself

1. An activity that is not a horse activity produced net income in 2022 and 2024 and losses in 2023, 2025 and 2026. Does the IRC § 183(d) presumption apply for 2026?

Answer: no. The presumption requires gross income to exceed deductions in 3 or more of the 5 consecutive taxable years ending with the taxable year — 2022 through 2026 — and only two of those years qualify. The activity may still be engaged in for profit; failing the presumption simply leaves the question to the facts and circumstances.

2. A taxpayer’s activity is determined not to be engaged in for profit. It produced $12,000 of gross income in 2026, and the taxpayer paid $3,000 of property taxes on land used in it and $15,000 of other operating expenses. What is deductible?

Answer: the $3,000 of property taxes, and nothing else. Property taxes are deductible without regard to profit motive, so they fall in the first tier of IRC § 183(b)(1). The operating expenses fall in the second tier, which IRC § 183(b)(2) would allow up to the excess of gross income over the first tier — but they are miscellaneous itemized deductions, and IRC § 67(h) disallows them for any year beginning after 2017.

3. A taxpayer begins a horse breeding activity in 2026 and makes the IRC § 183(e) election. Until when is the determination postponed?

Answer: until the close of the sixth taxable year following 2026, so the close of 2032. IRC § 183(e)(1) postpones the determination until the fourth taxable year following the first, substituting the sixth for an activity consisting in major part of breeding, training, showing or racing horses, and the presumption then applies across the 7-year period beginning with 2026.

4. A surgeon with $600,000 of employment income runs a small sailing charter that has lost money every year for six years, keeps no separate books, and uses the boat personally most weekends. Which factors are most likely to decide the case?

Answer: businesslike conduct and records, the unexplained continuation of losses, the substantial income from other sources, and the personal and recreational elements. Reg. § 1.183-2(b)(1), (6), (8) and (9) all point the same way here. No single one is determinative and the list is not exhaustive, but there is nothing on the other side of the ledger to weigh against them.

5. An S corporation’s activity is found not to be engaged in for profit. May the shareholders deduct their shares of its expenses?

Answer: no. IRC § 183(a) applies to an activity engaged in by an individual or an S corporation, so the disallowance operates at the entity level and the shareholders take gross income rather than a loss. The second-tier deductions that IRC § 183(b)(2) would permit are miscellaneous itemized deductions in each shareholder’s hands and are disallowed by IRC § 67(h).