Your chances of "winning" the audit lottery increase if you have wage income and file a Schedule C with large losses. And if the loss-generating activity sounds like a hobby -- horse breeding, car racing and such -- the IRS pays even more attention. Agents are specially trained to sniff out those who improperly deduct hobby losses. Large Schedule C losses are always audit bait, but reporting losses from activities in which it looks like you're having a good time all but guarantees IRS scrutiny.
You must report any income you earn from a hobby, and you can deduct expenses up to the level of that income. But the law bans writing off losses from a hobby. For you to claim a loss, your activity must be entered into and conducted with the reasonable expectation of making a profit. If your activity generates profit three out of every five years (or two out of seven years for horse breeding), the law presumes that you're in business to make a profit, unless IRS establishes otherwise. If you're audited, the IRS is going to make you prove you have a legitimate business and not a hobby. So make sure you run your activity in a businesslike manner and can provide supporting documents for all expenses.
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