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Hobby vs Business

Is your borrower’s business a hobby?

You may wonder why you should care if an individual, either your borrower or the guarantor of the business borrower, is playing a little fast and loose with the ‘hobby’ rules. I suggest there are two reasons:

  1. If your borrower is knowingly misleading the IRS to pay less taxes, they may be happy to knowingly mislead their lender to obtain a loan. One of the three requirements of fraud is that the perpetrator is willing to lie for gain. (I am well aware that fudging on the tax return may be seen differently than providing fraudulent info to your lender, but where is the fine line?)
  2. If the business is deemed a hobby by the IRS and hobby losses are disallowed, the borrower may be building up a back tax liability that is substantial. 

Example of a business loss that wasn’t

CliftonLarsonAllen is a CPA firm with some great blogs focused at different industries. Even though this blog post is in their AgLending section, it applies to us all. Read about a horse farm that was deemed a hobby by the IRS and the impact it had on the business owner.

How the IRS decides

  • Whether you carry on the activity in a businesslike manner and maintain complete and accurate books and records.
  • Whether the time and effort you put into the activity indicate you intend to make it profitable.
  • Whether you depend on income from the activity for your livelihood.
  • Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
  • Whether you change your methods of operation in an attempt to improve profitability.
  • Whether you or your advisors have the knowledge needed to carry on the activity as a successful business.
  • Whether you were 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 you can expect to make a future profit from the appreciation of the assets used in the activity.

So, should you care?

Writing off personal expenses and losses as if they were business is not a perk of being self-employed, it is fraud. That said, you may have a difference of judgement with a borrower as to whether those might legitimately be business and not hobby expenses. Be careful with your assumptions. But when a taxpayer is bragging about write-offs they know they are not entitled to, lender beware.

Linda Keith CPA
About the Author
Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis. She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans. Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.