How Section 183 Works

The rule itself is simple. If the IRS determines your activity lacks a genuine profit motive, it’s classified as a hobby. You still report every dollar of income from the activity — the IRS never lets you skip that part. But the expenses you incurred? They can only offset income from the activity, not from anything else. You can’t use a hobby loss to reduce your W-2 income from a film production job or your 1099 income from acting work.

Under the Tax Cuts and Jobs Act, the situation is even worse than it used to be. Before 2018, you could at least deduct hobby expenses up to hobby income as a miscellaneous itemized deduction. That deduction is gone through 2025. So right now, if you’re classified as a hobby, you pay tax on all the income and deduct nothing.

The 3-Out-of-5-Year Presumption

Show a profit in three out of five consecutive tax years and the IRS presumes you’re running a business under IRC Section 183(d). They can still argue otherwise, but the burden falls on them to prove you lack profit motive rather than on you to prove you have it.

This trips up a lot of LA-based creatives because entertainment income is inherently uneven. A screenwriter sells a script in 2022 for $80,000, earns $12,000 in residuals in 2023, then spends 2024 and 2025 writing a spec script that generates zero revenue and $25,000 in expenses. Two loss years in a row, plus one more slow year, and the presumption flips. The IRS can now reclassify the entire screenwriting activity as a hobby.

The feast-or-famine income pattern that defines Hollywood careers is exactly the pattern Section 183 was built to catch.

The 9 Factors the IRS Weighs

When the numbers alone don’t settle it, the IRS applies a nine-factor analysis from Treasury Regulation 1.183-2. Here’s what matters most for LA entertainment professionals:

• Businesslike manner: Separate bank account, organized records, contracts with clients, invoices. An actor with a spreadsheet of auditions, callbacks, and bookings looks different from one who can’t produce a single receipt.
• Expertise: Training, industry contacts, professional memberships (SAG-AFTRA, WGA, DGA). The IRS views these as evidence you’re serious, not just dabbling.
• Time and effort: Hours matter. A director spending 50 hours a week developing a project has a different profile than someone editing a short film on weekends.
• Expectation of asset appreciation: Building a library of produced content, developing intellectual property, or growing a brand that has future sale value.
• Prior success: Previous ventures you turned profitable weigh in your favor.
• Profit history: Startups lose money early. But ten years of losses with no upward trend is a problem.
• Occasional profit amounts: One year of big earnings surrounded by losses still shows the activity has real commercial potential.
• Financial status: High earners with consistent side-project losses attract more scrutiny. The IRS suspects the losses are the point, not the project.
• Personal pleasure: You enjoy making films. Of course you do. But enjoyment alone doesn’t make it a hobby — the IRS has to show that pleasure, not money, is why you do it.

Why California’s Tax Rate Makes This Worse

California’s top individual income tax rate is 13.3% — the highest in the country. When the IRS reclassifies your business as a hobby, you lose deductions at both the federal and state level. On a $20,000 disallowed loss, the combined federal and California hit is roughly $8,000 to $9,000 for someone in the top brackets.

California’s Franchise Tax Board (FTB) generally follows federal hobby loss determinations. So an IRS reclassification triggers a state adjustment automatically. You don’t get a second chance to argue your case in Sacramento — the federal result carries over.

There’s no separate city income tax in LA, which is one small consolation compared to a place like New York. But the state rate alone is steep enough that losing your Schedule C deductions changes the math on whether the entire side project was worth pursuing financially.

Entertainment Industry Specifics

The IRS has audited entertainment professionals over hobby loss issues for decades, and Tax Court has built up a body of cases specific to the industry. A few patterns stand out.

Actors and directors who incorporate their entertainment activities into a loan-out corporation (an S-corp or C-corp that contracts their services to studios) have a structural advantage. The entity itself signals that the activity is being run as a business, not a weekend project. It’s not a silver bullet — the IRS can still look through the entity — but it shifts the optics.

Content creators on YouTube, TikTok, and Instagram face newer versions of the same old question. A creator spending $30,000 a year on equipment, travel, and production while earning $8,000 in ad revenue and brand deals will eventually have to justify the losses. The key is documenting a growth strategy: subscriber targets, pitch decks for sponsors, revenue projections grounded in actual data.

Protecting Your Deductions

Open a separate business bank account and run every dollar of income and expense through it. Keep a business plan on file — it doesn’t need to be long, but it should show revenue targets, a timeline, and what you’re doing to get there. Log your hours. Save contracts, invoices, and correspondence with clients or collaborators.

If you’re in your first few years and expect losses, Form 5213 lets you postpone the hobby-versus-business determination until you have five years of data. It buys time, but it also extends how long the IRS can audit those early returns.

Get a CPA involved early. The cost of cleaning up a hobby loss reclassification — amended returns, penalties, interest, and potentially Tax Court — dwarfs the cost of setting up proper records from the start. If you’re also deciding how to structure your entity, see our sole proprietorship vs LLC guide for Los Angeles.

Sources & References

• 26 U.S.C. § 183 — Activities Not Engaged in for Profit
• 26 CFR § 1.183-2 — Activity Not Engaged in for Profit Defined (9-Factor Test)
• IRS Publication 535 — Business Expenses
• IRS Form 5213 — Election to Postpone Determination
• California FTB — Personal Income Tax Rates
• IRS Publication 529 — Miscellaneous Deductions