The hobby versus legitimate business is a common question. We have written a series of KB articles on this topic as well.
Here is a quick summary- First, the IRS suggests that incorrect deduction of hobby expenses account for a portion of the overstated adjustments, deductions, exemptions and credits that add up to $30 billion per year in unpaid taxes. So there is a bit of an incentive for the IRS to tackle this issue head on.
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, taxpayers should consider the following factors:
Again, the main theme is reasonable expectation of earning a profit. 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. Having said that, there is a recent Tax Court case docketed October 25 2012 showing how a taxpayer with eight consecutive years of losses was able to demonstrate that his business was trying to earn a profit.
Read the full opinion at www.watsoncpagroup.com/Coach.pdf.
We also encourage you to read our article on the Hobby versus Business topic- it expands on this question and answer more in depth.