Legal Definitions - three-of-five test

The three-of-five test is a guideline used by the U.S. Internal Revenue Service (IRS) to help determine whether an activity is considered a genuine business or merely a hobby for tax purposes. This distinction is critical because it affects whether losses from the activity can be used to reduce a taxpayer's other taxable income.

Under this test, if an activity does not generate a profit in at least three out of the last five consecutive tax years, the IRS will generally presume it is a hobby. This is a rebuttable presumption, meaning that while the IRS initially assumes it's a hobby, the taxpayer can present evidence to prove they genuinely intended to make a profit, even if they haven't been consistently successful.

If an activity is classified as a hobby, any losses incurred from it generally cannot be used to offset other income, such as wages or investment earnings. This means the taxpayer cannot use those losses to reduce their overall tax liability.

• Example 1: The Weekend Woodworker

  Mark enjoys woodworking and occasionally sells custom furniture and decorative items online and at local craft fairs. Over the past five years, he has consistently spent more on tools, materials, and booth fees than he has earned from sales. Specifically, he reported net losses in year 1, year 2, year 3, and year 5, with a very small profit only in year 4.

  How it illustrates the term: Mark's woodworking activity generated a profit in only one of the last five years. Since it did not show a profit in at least three of those five years, it fails the three-of-five test. The IRS would likely presume his woodworking is a hobby, meaning he generally cannot use the losses from this activity to reduce his taxable income from his primary employment.

• Example 2: The Aspiring Online Retailer

  Sarah launched an online boutique selling unique imported goods five years ago. She invested heavily in inventory and marketing, hoping to build a profitable business. She managed to make a modest profit in year 2 and year 4, but incurred losses in year 1, year 3, and year 5 due to high shipping costs and intense competition.

  How it illustrates the term: Sarah's online boutique made a profit in only two of the last five years. Because it did not meet the "three-of-five" profit threshold, it would initially be presumed a hobby by the IRS. Sarah would then need to demonstrate a clear profit motive through other factors (like maintaining detailed business records, adjusting pricing, or seeking expert advice) to convince the IRS it is a legitimate business and allow her to deduct her losses.

• Example 3: The Innovative Agricultural Startup

  A small team started an innovative vertical farm five years ago, focusing on sustainable, high-yield produce. The initial years (year 1, year 2, year 3) involved significant research and development costs, leading to substantial losses. In year 4, they broke even, and in year 5, they achieved their first significant profit as their technology matured and market share grew.

  How it illustrates the term: This startup technically only showed a clear profit in one of the last five years (year 5), and broke even in another (year 4). This means it would initially fail the three-of-five test. However, this is a prime example of where the "rebuttable presumption" is crucial. The founders could present evidence such as a comprehensive business plan, significant capital investment, efforts to optimize operations, and the eventual profitability, to demonstrate their clear intent to operate a for-profit business, thereby allowing them to deduct the losses incurred during the development phase.