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Lev
Lev, Tax Advisor
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Experience:  Taxes, Immigration, Labor Relations
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Does the 3-out-of-5 profit/loss tax rule (guideline) typically

Resolved Question:

Does the 3-out-of-5 profit/loss tax rule (guideline) typically used for Hobby vs Business for Schedule C filers applicable to LLC-Partnerships?
Submitted: 3 years ago.
Category: Tax
Expert:  Lev replied 3 years ago.

LEV :

Hi and welcome to Just Answer!

LEV :

Yes - that is correct - regardless how the activity is structures - if you report losses and use these losses to offset other taxable income - the IRS normally would evaluate if the activity is a business or a not for profit activity (i.e. hobby)


Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit.

LEV :

Because your expectations or intentions are hard to proof - the IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year.


If your activity doesn't generate a profit - the IRS most likley will classify it as not for profit or hobby. If an activity is not for profit, losses from that activity may not be used to offset other income. Deductions for hobby activities are claimed as itemized deductions on Schedule A (Form 1040).

LEV :

However in some situations - it is possible that more than two years needed for the business to become profitable. That will be your responsibility to proof that.


In order to make this determination - following factors should be used for distinguishing hobby vs. business activities:


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?


 


So depending on your specific situation it is possible to have business losses more than two years, but again - we are in the gray area - and you might want to avoid possible litigation.

LEV :

Please let me know if you any help or clarification.

Customer:

Thanks,My understanding is that for Corporation C

Customer:

the IRS has said 3-5 rule does NOT apply..is that correct?

LEV :

The issue is that C-corporations generally may not pass losses to shareholders - so if the C-corporation has losses they are not used to offset other income and there is no reason to determine if its activities are carried on for profit or not.

Customer:

Right - that confirms my understanding , thanks

Lev, Tax Advisor
Category: Tax
Satisfied Customers: 22655
Experience: Taxes, Immigration, Labor Relations
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