I am an engineer by day, and run a one-boat charter business (LLC) on the evenings and weekends in the summer. This is my third year in business and I do all of the work myself (No employees). I did not make a profit my first two years. The reason for not making a profit is primarily depreciation of the boat, when added to other expenses. I make between 15-20k per year doing charters, however the depreciation on the boat for the first three years is 7k, 12k, and 8k respectively. I am on track to make a profit this year (third year) weather pending. My question is, if for some reason I do not make a profit this year or next, am I at risk of being labeled as a hobby by the IRS, where expenses would no longer be deductible? I am making a profit, but depreciation could show a loss on paper.
Note: In order to run this business I had to go to school to get my captains licensee; federal, state, and local permits are required each year; safety gear has to be kept current; and I keep separate business bank accounts.
Your scenario involves a facts and circumstances test and the relevant factors are laid out in Treas. Reg. §1.183-2 (link below).
Per Code Section 183(d), taxpayers are allowed a safe harbor whereby it is presumed the activity is engaged in for profit if in 3 of 5 consecutive years the activity is profitable.
Your fear is backwards. If you were claiming this as hobby income, I would be more concerned with the IRS labeling it as self-employment business income. Not the other way around.
Basically, if your "intent" is to make a profit, then what you have is a business and not a hobby. Weather you actually make a profit or not doesn't matter. It's your "intent" that matters.
Generally speaking, the IRS does not expect a newly formed business to actually make a taxable profit in the first three years. That does not mean that you must make a profit in the 4th year either. I've known businesses to go as long as 5 years before actually making a taxable profit in the 6th year.
Where flags are raised is when you have a business for 3 plus years that never makes a profit and operates at a loss, and you sell the business at a gain. Then you use the deferred losses to offset the taxability of the gains on the sale. When such flags are raised that does not insinuate you've done anything wrong either. It just "raises eyebrows" and it's possible you could be asked to "prove your intent". Easy to do if making a profit really was your intent.
Just be advised that simply stating an intent to make a profit does not outweigh the facts and circumstances, as expressly stated in the Regulation cited:
In determining whether an activity is engaged in for profit, greater weight is given to objective facts than to the taxpayer's mere statement of his intent.