Legal Definitions - three-of-five test

The three-of-five test is a rule used by the Internal Revenue Service (IRS) to determine whether a business venture is a hobby or a legitimate business. According to this rule, if a business venture does not make a profit for three out of the last five consecutive years, it is considered a hobby and not a business for tax purposes.

For example, if a person starts a small business selling handmade crafts and does not make a profit for three out of the last five years, the IRS may consider it a hobby rather than a legitimate business. This means that any losses incurred by the business cannot be used to offset other income.

Another example could be a person who invests in rental properties but does not make a profit for three out of the last five years. The IRS may consider this a hobby rather than a legitimate business, and any losses incurred cannot be used to offset other income.

The three-of-five test is a rebuttable presumption, which means that the taxpayer can provide evidence to prove that the business is a legitimate business and not a hobby. However, it is important to keep accurate records and demonstrate a profit motive to avoid being classified as a hobby by the IRS.