Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit. In order to make this determination, the IRS feels taxpayers should consider the following factors: 

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 or 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?

The PRESUMPTION tests. 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 (at least two of the last seven years for activities that consists primarily of breeding, showing, training, or racing horses.)

TAX RESULTS IF ACTIVITY IS A HOBBY. If an activity is not for profit, losses from that activity may not be used to offset other income. The  limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.

DEDUCTIONS FOR HOBBY ACTIVITIES ARE CLAIMED AS ITEMIZED DEDUCTIONS ON SCHEDULE A (FORM 1040). These hobby deductions must be taken in the following order and only to the extent stated in each of three categories:

 1.  Deductions that a taxpayer can take for personal as well as business activities, such as home mortgage interest and taxes, can be taken in full.
 
 2.  Deductions that do not result in an adjustment to basis, such as advertising, insurance premiums, and wages, can be taken next, to the extent gross income from the activity is more than the deductions from the first category.

 3.  Business deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.