Short answer:
YES.
A business can absolutely lose money and still be considered legitimate by the IRS. In fact, many real businesses operate at a loss, especially in the early years.
But there’s a line between a real business with losses and what the IRS calls a hobby - that distinction matters a lot when it comes to your taxes.
WHY BUSINESSES LOSE MONEY
Losing money doesn’t automatically raise red flags. There are plenty of valid reasons:
- Startup costs – equipment, branding, website, inventory
- Growth investments – marketing, hiring help, expanding services
- Industry cycles – some businesses are seasonal or take time to gain traction
- Economic conditions – slow markets, inflation, or unexpected expenses
It’s completely normal for a business to take time before becoming profitable.
The IRS “Profit Motive” Test
The IRS isn’t expecting you to be profitable every year, but they do expect you to be trying to make a profit.
A common guideline is the “3 out of 5 years” rule:
If your business shows a profit in at least 3 of the last 5 years, the IRS generally assumes it’s legitimate. But, even if you don’t meet that rule, you can still qualify as a business. The IRS looks at the bigger picture.
HOW THE IRS DECIDES IF IT’S A REAL BUSINESS
They evaluate whether you’re operating with a genuine intent to make money. That includes things like:
- Keeping accurate books and records
- Having a business plan or strategy
- Actively marketing or trying to grow
- Treating it like a business (separate accounts, professionalism)
- Adjusting your approach if something isn’t working
In other words, are you acting like a business owner, or just funding a passion project?
What Happens If It’s Considered a Hobby?
If the IRS determines your activity is a hobby:
- You still have to report the income
- But you can’t deduct your expenses
That means you could end up paying taxes on money you didn’t actually keep, which is not a great place to be.
Red Flags To Be Aware Of
Consistent losses alone aren’t the problem, but paired with these points, they can raise concerns:
- No clear effort to make a profit
- Mixing personal and business finances
- No records or documentation
- Running losses year after year with no changes
- The activity looks primarily for personal enjoyment
Think of it this way: You don’t need to be successful, but you do need to be serious.
THE BOTTOM LINE
A business doesn’t need to be profitable to be legitimate, but it does need to be intentional. Losses are part of the journey for many entrepreneurs. What matters is whether you’re operating with a real plan to eventually turn a profit.
You Don’t Have to Navigate This Alone
Moore Paquette specializes in helping business owners stay compliant while building toward profitability. Let’s talk.
This content is for general informational purposes only and should not be considered tax or legal advice. Every situation is different, please consult with a qualified professional regarding your specific circumstances.