Written By: Kevin Jerry / May 1, 2024

This question should be straightforward. Unfortunately, it is not. The misunderstanding of this topic is because some hobbies can generate revenue and profits. Many hobbies are challenging to differentiate from a trade or business. A trade or business can take tax deductions, but hobbies generally cannot.

Since the Tax Cuts and Jobs Act (TCJA) passed in 2017, this topic has become very pertinent because a trade or business is allowed a §199A tax deduction for qualified business income (QBI).

How to Determine Hobby or Business

Unfortunately, this decision has no bright lines in the Regulations. While many regulations refer to the status as a trade or business, nowhere in the Code or regulations is it defined. So, the definition of a trade or business has been interpreted by the courts.

The de facto case for differentiating a trade or business from a hobby comes from the Groetzinger case, which dates back to 1987. The Groetzinger case concerned a professional gambler and whether his expenses were a legitimate business deduction. The case went to the Supreme Court.

One of the most significant concerns surrounding whether an activity constitutes a trade or business is the allowance of deductions. §162(a): “There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” If an activity is a hobby, no deductions may be taken against income resulting from that activity.

The Supreme Court ruled: “To be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity, and the taxpayer’s primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify.”

If an activity fails to qualify as a trade or business because it is not engaged in for profit, it is considered a hobby, and §183 applies. §183(d) states that generally, any activity with more revenue than deductions in at least three out of the five consecutive years is for profit and, therefore, a trade or business. The IRS looks at any loss in more than three out of five years as a not-for-profit hobby.

The final determination is now nine nonexclusive relevant elements in §183-2(b).  Here are the nine determining factors:

1. The way the taxpayer carries on the activity.
2. The expertise of the taxpayer.
3. The time and effort expended by the taxpayer in carrying on the activity.
4. The expectation is that assets used in the activity may be appreciated.
5. The taxpayer’s success in carrying on other similar activities.
6. The taxpayer’s history of income or losses with respect to the activity.
7. The amount of profit, if any, that is earned.
8. The taxpayer’s financial status.
9. Elements of personal pleasure or recreation.

If no profit motive is present, the activity fails to qualify as a trade or business, and the deduction rules of §183 apply. §183 limits deductions to the gross income from the activity. The expenses must be added to miscellaneous deductions, which the TCJA suspended for tax years 2018 through 2025.