If IRS decides your business is a hobby, does that mean audit and/or a penalty?

[Regsa]

If IRS decides your business is a hobby, does that mean an audit and/or a penalty?

Or do they just send you a letter disallowing your Schedule C business deductions, without penalty and without audit?

[tagteam]

See https://www.irs.gov/newsroom/know-the-difference-between-a-hobby-and-a-business

You might not be penalized but you might owe additional tax which would entail interest on the past due amount.

[Regsa]

Thanks Champ. My estimated tax payment is large enough to cover the tax if my deductions are disallowed. I am more concerned with the audit and penalty. Are these likely and is the penalty large? My business is very small and in a foreign country. And if I decide the risk of penalty is not worth it, and decide not to take the deductions, what do I do? Do I just not file a Schedule C at all? Or list the loss in Schedule C but then don’t take the loss on Schedule 1 (Form 1040), line 3, and on Schedule SE, line 2? Thanks again.

[tagteam]

You need to decide whether this is a business or a hobby based upon the following factors:

• Whether the activity is carried out in a businesslike manner and the taxpayer maintains complete and accurate books and records.
   
• Whether the time and effort the taxpayer puts into the activity show they intend to make it profitable.
   
• Whether they depend on income from the activity for their livelihood.
   
• Whether any losses are due to circumstances beyond the taxpayer's control or are normal for the startup phase of their type of business.
   
• Whether they change methods of operation to improve profitability.
   
• Whether the taxpayer and their advisors have the knowledge needed to carry out the activity as a successful business.
   
• Whether the taxpayer was successful in making a profit in similar activities in the past.
   
• Whether the activity makes a profit in some years and how much profit it makes.
   
• Whether the taxpayers can expect to make a future profit from the appreciation of the assets used in the activity.

See Earning side income: Is it a hobby or a business? | Internal Revenue Service (irs.gov)

[Regsa]

Also, I don’t see anything on the link you provided that talks about the 3 out of 5 year rule (it’s a business if you show a profit in 3 out of 5 years) I thought that was the main rule. Anyway, my business was dormant in its first 2 years with 2 dormant 8858s filed; 2023 was the third year of the business and first year the business became active, but still no profits, just expenses. If I explain this in an attachment, do you think it makes a difference?

My main concern is that if there’s any chance of penalties, it’s not worth it to me to try to take the loss.

[tagteam]

Penalties should not be a concern unless your position is completely unreasonable. 

[tagteam]

---

@Regsa wrote:

.......it’s a business if you show a profit in 3 out of 5 years) I thought that was the main rule. 

---

That is the presumption, and it is rebuttable. 

Note that there is no inverse presumption (i.e. there is no presumption that the activity is a hobby if you show a loss in 3 out of the last 5 years).

[Regsa]

It’s definitely a business, it’s just been slow getting started. It’s registered as a business in both the country where it is located and in the US. It has an EIN number. It just hasn’t made a profit yet, but I intend it to make profits in the next year.