Factor #1 of the IRS Hobby Loss Test: Are You Actually Running a Business?

A closer look at the first — and arguably most important — factor the IRS uses to decide whether your breeding program is a business or a hobby.

Taxes in a breeding program affect you whether you are a hobby or a business. If you are a hobby, you report all gross income and no expenses. If you are considered a business, you get to deduct all ordinary and necessary expenses of running that business from your gross income. If you’ve been following along, you know the stakes: under IRS Section 183, the “Hobby Loss Rule,” a breeding program classified as a hobby can’t deduct its losses, and thanks to the One Big Beautiful Bill Act making the 2018 suspension of miscellaneous itemized deductions permanent, hobby expenses aren’t deductible at all anymore. You’d owe tax on every dollar of stud fee and puppy income with nothing to offset it (except Cost of Goods Sold, and that’s a different calculation). That’s the whole reason the nine factors in Treasury Regulation § 1.183-2(b) matter so much — they’re how the IRS decides which side of that line you’re on.

Today we’re going deep on Factor #1: the manner in which you carry on the activity.

This factor usually comes first in the regulation for a reason. It’s the most behavioral of the nine — it isn’t about your background, your bank account, or how your program has performed historically. It’s about whether, day to day, you run your breeding program the way a person who genuinely intends to profit would run it. And unlike some of the other factors, this one is almost entirely within your control- Regardless of how long you’ve been breeding or how your program has performed so far.

What “Manner of Carrying On” Actually Means

When an examiner evaluates this factor, they aren’t looking for perfection. They’re looking for a pattern of business-like conduct. They are looking for evidence that decisions are being made deliberately, with profit in mind, rather than the program simply happening around you. Treasury Regulation § 1.183-2(b)(1) points to several specific indicators, and each one shows up constantly in real hobby-loss cases:

Do you maintain complete and accurate books and records? Not a shoebox of receipts sorted once a year before tax time. We are talking about an ongoing system that separates business income and expenses, categorizes them meaningfully, and could be handed to a tax preparer or an examiner without a scramble. This could be on a spreadsheet that is consistently maintained or a full blown accounting system utilized regularly.

Is the activity conducted in a manner substantially similar to comparable businesses that are profitable? In other words, do you do the things a profitable kennel or cattery does. Do you price based on actual cost & value of the kitten or puppy. Do you track margins by litter. Do you evaluate which pairings or services are worth continuing?

Have you changed operating methods, adopted new techniques, or abandoned unprofitable methods in an attempt to improve profitability? This is the single most underused piece of evidence in breeder cases, and it’s free. If you raised your prices after realizing vet costs outpaced income, stopped offering a service that consistently lost money, switched vendors to cut costs, or dropped a bloodline that wasn’t producing — that’s exactly the kind of course-correction the regulation is looking for. And the key is to write it down when it happens. This provides documentation in the event the IRS asks questions.

Do you have a business plan, and does it reflect real financial projections rather than wishful thinking? A plan that says “I’ll breed a few litters and see what happens” reads very differently to an examiner than one that lays out expected costs per litter, target pricing, projected annual revenue, and a path to profitability.

Is there a separate business bank account? This sounds almost too simple to matter, but commingling breeding income and expenses with your personal checking account is one of the fastest ways to look like a hobbyist, because it suggests the money was never really being managed as a business in the first place.

Why Breeders Get This Wrong

Here’s the uncomfortable truth: most breeders who lose a hobby-loss determination don’t lose it because they weren’t serious about their program. They lose it because they never translated that seriousness into a documented paper trail. You can pour thousands of hours into genetics, health testing, and 3 a.m. whelping watches and still fail this factor, because the IRS isn’t grading your dedication to the dogs or cats — it’s grading your dedication to running this as a business.

The other common trap is treating recordkeeping as something you’ll clean up “if it ever comes up.” By the time an examination starts, it’s too late to reconstruct a business plan you never wrote or a decision you can’t prove you made in real time. Documentation created contemporaneously — at the time something actually happened — carries far more weight than anything assembled after the fact. That’s not a technicality; it’s the difference between evidence and a story. AND it is so much easier to document as events happen and you don’t have to rely on memory.

The good news is that none of this requires you to become a bookkeeper overnight. It requires a handful of specific habits, done consistently, starting now.

Your Action Step: Run a One-Week Business Practices Audit

You don’t need to overhaul your entire program this week. You need to establish — and start documenting — the four things examiners actually look for. Here’s how to do it on your own, no membership required:

1. Open a dedicated business bank account. If your breeding income and expenses currently run through your personal account, open a separate checking account this week and start routing everything through it going forward. This alone is one of the fastest, most visible signals of business intent.

2. Write a one-page business plan. It doesn’t need to be polished. On a single page, write down: what you breed and why, your target market, your pricing and how you arrived at it, your estimated annual costs (vet care, health testing, feed, registration, facilities), your projected revenue, and one or two goals for improving profitability this year. Date it. If you would like a more detailed business plan that could potentially be very eye opening, we have one available for download to all our members of the Breeder Biz Advisor membership. You can take this plan and truly make it your own and have it completed in an afternoon or evening. This is also a plan you could present to lenders if you are thinking of expanding your kennel or cattery.

3. Start a decision log. Open a simple document or notebook and log every business decision you make going forward that’s aimed at profitability — a price change, a vendor switch, a service you added or dropped, a bloodline decision made partly for financial reasons. One or two sentences per entry, dated. Six months from now, this log alone can be some of your strongest evidence.

4. Set up a basic bookkeeping system. It can be as simple as a well-organized spreadsheet with income and expense categories that match how your program actually runs, updated weekly or monthly rather than reconstructed once a year. The goal isn’t fancy — it’s consistent and contemporaneous. I have built a robust accounting workbook that can be used in your breeding program and even has line by line mapping to know where to enter items on your tax return. All included in the Breeder Biz Advisor membership.

Do these four things and you will have materially strengthened your position on the single factor that most breeders never think about until it’s too late — and you’ll have done it in a week, on your own.

Where Breeder Biz Advisor Comes In

That one-week audit is a genuinely good start, and you can absolutely stop there. But “manner of carrying on the activity” is only one of nine factors, and building the system that keeps it — and the other eight — documented month after month, year after year, is a different level of effort than a single week of setup. That’s exactly what Breeder Biz Advisor is built for: this membership includes tons of templates and documents such as; a breeding-program-specific chart of accounts that can be used in an existing accounting program, there is even an Excel Accounting Workbook that can used as your accounting system complete with graphic dashboards so you can see in real time how your breeding program is performing financially; a business plan framework that can customized to your program, quarterly tax guidance, and a community of breeders working through the same issues, all built by people who work with breeding programs — not generic small-business content with a dog photo pasted on it. We will have monthly calls to get your specific tax or business questions answered, by a CPA who was also a breeder.

Right now, founding member pricing is available while we continue building out the library — it won’t stay open forever.

👉 Join as a founding member: https://breederbizadvisor.circle.so/checkout/foundingmember

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This article is general educational information, not tax or legal advice for your specific situation. Section 183 determinations depend heavily on individual facts. Please consult a qualified tax professional about your breeding program.