What are the practical consequences? Under the so-called hobby loss rules, you’ll be able to claim those deductions that are available whether or not the enterprise is engaged in for profit (such as state and local property taxes). However, your deductions for business-type expenses (such as rent or advertising) will be limited to the excess of your gross income from the hobby over those expenses that are deductible whether or not the enterprise is engaged in for profit. Deductible hobby expenses are claimed on Schedule A of Form 1040 as miscellaneous itemized deductions subject to a 2%-of-AGI “floor.” By contrast, if the new enterprise isn’t affected by the hobby loss rules, all otherwise allowable expenses would be deductible on Schedule C, even if they exceeded income from the enterprise.

There are two ways to avoid the hobby loss rules. The first way is to show a profit in at least three out of five consecutive years (two out of seven years for breeding, training, showing, or racing horses). The second way is to run the venture in such a way as to show that you intend to turn it into a profit-maker, rather than operate it as a mere hobby. The IRS regs themselves say that the hobby loss rules won’t apply if the facts and circumstances show that you have a profit-making objective.

How can you prove that you have a profit-making objective? In general, you can do so by running the new venture in a businesslike manner. More specifically, IRS and the courts will look to the following factors: how you run the activity; your expertise in the area (and your advisers’ expertise); the time and effort you expend in the enterprise; whether there’s an expectation that the assets used in the activity will rise in value; your success in carrying on other similar or dissimilar activities; your history of income or loss in the activity; the amount of occasional profits (if any) that are earned; your financial status; and whether the activity involves elements of personal pleasure or recreation.

The classic “hobby loss” situation involves a successful businessperson or professional who starts something like a dog-breeding business, or a farm. But IRS’s long arm also can reach out to more prosaic situations, such as businesspeople who start what appears to be a bona-fide sideline business.