Thank you for using justanswer. According to the IRS, there must be an intention to make a profit from an activity, otherwise IRS may rule is as a hobby (which is your current situation)
These are the criteria IRS lists as some of the deciding factors in determining whether you have a business or a hobby on their Business or Hobby? Answer Has Implications for Deductions
Does the time and effort put into the activity indicate an intention to make a profit?
Does the taxpayer depend on income from the activity?
If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
Has the taxpayer changed methods of operation to improve profitability?
Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
Has the taxpayer made a profit in similar activities in the past?
Does the activity make a profit in some years?
Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?
There are, of course, additional factors that may help you case, for example:
First, and foremost, you must TREAT this as a business. Do you advertise, have you set up a separate bank account so that you are not "comingling" the money from this venture with your personal income (a huge no no for IRS if you want them to view this activity as a business). Do you approach this activity with the same intention as you do your job a a physician. I don't meant with the same intensity, but when you see a patient, there is absolutely no way that your job as a physician could ever be considered a hobby, and I'm sure you would do whatever it took to grow your business since it is your main source of income.
To a certain extent, "intent" is an intangible thing, so just saying that your intention of running the fitness center was to make a profit usually isn't enough in and of itself to sway the IRS that this is a business after you have more than a few years of losses. If you want the IRS to view this activity as a business, you must treat it as one.
The IRS's request to prove your 500 hours of partcipation is truly only one piece of the puzzle, (and as you stated, difficult to prove) That alone should not be the sole criteria. If you were my client, I would craft a letter that inluded many (if not all) of the criteria listed in the IRS website that I mentioned above. Ex: My client has always intended to for this fitness center to be a business, and has taken every step to make it profitable.He spends sufficient time there every day to make sure that the equipment is in good working condition, checking on his patients and others that make use of this equipment to ensure they do so in a manner that is not detrimental to their health. He has avertised this fitness center in order to bring in enough clients to help make it profitable. ( Note: if you have never listed any advertising expenses on your tax return for this business, then unless you can prove that you listed it on something like Craig's space or other free advertising service, then you may not want to mention the advertising. The last thing you want to do at this point is mis lead the IRS.) If you had business cards made for the business, that would qualify as advertising also. I would then continue down their list, showing how I complied with their criteria and was treating this as a busines.
I hope this helps.