​Do you have an activity that you do on the side that you think of as a business? Are you claiming losses on your personal tax return (Schedule C, Form 1040)? Will the IRS allow those losses?

I have had a few questions lately about what the IRS considers to be a hobby and what it considers to be a business. If a business, losses are deductible. If a hobby, you can only deduct expenses up to your revenue and therefore are unable to deduct a loss.

The IRS likes to claim that money-losing sideline activities are hobbies rather than businesses. The federal income tax rules for hobbies have been anti-taxpayer for years, and an unfavorable change enacted in the Tax Cuts and Jobs Act (TCJA) made things even worse for 2018-2025.

If you have such an activity, I should have your attention.

Here’s the deal: if you can show a profit motive for your now-money-losing sideline activity, you can classify that activity as a business for tax purposes and deduct the losses. If you can't, you don't get to deduct the losses.

Factors that can prove (or disprove) such for-profit intent include:

• Conducting the activity in a business-like manner by keeping good records and searching for profit-making strategies.
• Having expertise in the activity or hiring advisors who do.
• Spending enough time to justify the notion that the activity is a business and not just a hobby.
• Expectation of asset appreciation: this is why the IRS will almost never claim that owning rental real estate is a hobby, even when tax losses are incurred year after year.
• Success in other ventures, which indicates that you have business acumen.
• The history and magnitude of income and losses from the activity: occasional large profits hold more weight than more frequent small profits, and losses caused by unusual events or just plain bad luck are more justifiable than ongoing losses that only a hobbyist would be willing to accept.
• Your financial status: “rich” folks can afford to absorb ongoing losses (which may indicate a hobby), while ordinary folks are usually trying to make a buck (which indicates a business).
• Elements of personal pleasure: breeding race horses is lots more fun than draining septic tanks, so the IRS is far more likely to claim the former is a hobby if losses start showing up on your tax returns.

The IRS starts looking at these activities when losses are deducted on a consistent basis (more than three out of the last five years).

If you have a loss-producing activity that you consider a business but the IRS might consider a hobby, it would be wise to firm up your supporting factors to make sure that it looks and smells more like a business than a hobby.

Well, that was quick...what a difference a week makes.

Due to the overwhelming pressure from CPAs, State Societies, Enrolled Agents and other organizations, the IRS announced ​late on Tuesday February 15th that certain domestic partnerships and S corps qualify for special relief from having to prepare the new K-2 and K-3 forms if they have no foreign activities, foreign partners, or shareholders. The IRS said, "For 2021, these qualifying domestic partnerships and S corporations will not have to file the new schedules,” ... “We are taking this step in response to feedback we received from the tax community and our stakeholders. The IRS will provide full details of this relief soon.”

It seems we have an extra year to get processes in place to determine if the individual taxpayer owners of pass-through entities are eligible to file Form 1116 to claim a foreign tax credit and thus the entity needs to file the K-2/K-3 forms. Hopefully, it won't be as hectic in 2023 when trying to file next tax season.

Last year in June, the IRS issued two new form schedules to accompany pass-through entity returns (Forms 1065 and 1120S) starting in the 2021 tax year - The Schedule K-2 and K-3. The K-2 consists of 11 parts over 19 pages and the K-3, 13 parts over 20 pages. The purpose of these schedules is to help reduce money laundering, better improve international activity reporting and to report foreign activity at the entity level to the individual owners. The IRS also issued draft instructions shortly after issuing the schedules which stated that the forms would be required if the entity had foreign transactions (“Who Must File: The partnership need not complete this schedule if the partnership does not have items of international tax relevance (typically, international activities or foreign partners)”) .

A couple of weeks ago, the IRS issued final instructions and with them a trap. Instead of the trigger for the schedules being at the entity level, the trigger now resides at the individual owner level. Even if the entity did not have foreign transactions, the entity must file these schedules if the owner claims a foreign tax credit (Form 1116) on their personal returns.

As such, every pass-through entity needs to determine if it has items of international tax relevance with respect to its direct and indirect owners. A U.S. entity with no foreign-sourced income, no assets generating foreign-sourced income, no foreign taxes paid or accrued, and no foreign owners may still need to report information on Schedules K-2 and K-3 if an owner is eligible to claim a credit for foreign taxes paid on other sources of foreign income on their own tax return.

The forms are required if the entity lacks positive evidence that each owner is not eligible to claim a foreign tax credit on their return. Put another way, if the entity is unsure if an owner may be claiming a foreign tax credit on their return, these new forms are required.

Penalties for failing to file these forms can be as much as $570 per missing form.

The process of gathering, analyzing, and reporting all of this data that is now required is complex and may consume a substantial amount of time, resources, and significantly increase the cost to complete properly.

Costs for return preparation when these forms are required will double or triple when compared to returns without them.

To avoid penalties and be in compliance, I will be requiring positive evidence from each entity owner that they are not subject to filing Form 1116 as part of their individual returns or I will prepare the extra schedules and charge for them.

There is still a lot unknown and undetermined about these new forms, as they are complex and extensive and may require many filers to be placed on extension.