If the expenses of your sideline business exceed its revenues, it's reasonable to think you can deduct the loss on your return. Think again. The Internal Revenue Service may claim your purported business is a hobby that never had a chance of being profitable and the tax rules for hobby losses are not in your favor.

When your unincorporated for-profit business activity generates a net tax loss for the year -- deductible expenses in excess of taxable revenue -- you can deduct the loss on Form 1040. Use Schedule C to report a loss from a sole proprietorship business, and use Schedule F to report one from a farming or ranching venture. The loss is then carried to page 1 of Form 1040, where it offsets income from other sources and reduces your tax bill.

But if the IRS determines your activity is a hobby, you can't deduct a loss. In this case, you report all the revenue on page 1 of Form 1040, but your allowable expenses are limited to the amount of that revenue. In other words, you can never have a net tax loss from a hobby even if you lose your shirt. Even worse, you must treat the total amount of hobby expenses, limited to income, as a miscellaneous itemized deduction item on Schedule A. So you get no write-off unless you itemize.

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Even if you do itemize, your write-off for miscellaneous deduction items is limited to the excess of those items over 2% of adjusted gross income (AGI). If you have a healthy AGI, your deduction for hobby expenses may be little or nothing. Finally, if you're a victim of the dreaded alternative minimum tax (AMT), hobby expenses are completely disallowed under the AMT rules.

When all is said and done, you can easily have a money-losing hobby that actually adds to your taxable income, because you have to report all the income and may not be able to report much, if any, of the expenses. Your tax bill goes up accordingly.

But don't give up hope. The good news is yet to come.

Fortunately, the tax law automatically assumes you have a for-profit business if the activity produces positive taxable income (revenues in excess of deductions) for at least three out of every five years. Losses from the other years can be deducted because they are considered to be legitimate business losses as opposed to nondeductible hobby losses. For horse racing, breeding, training, or showing activities, you're assumed to have a for-profit business if you can generate positive taxable income in two out of every seven years. Those who can plan ahead to pass these tests earn the right to deduct their losses from the unprofitable years.

Even if you can't pass one of these canned profitability tests, you may still be able to treat your activity as a for-profit business and rightfully deduct your losses. Basically, you must demonstrate that you have an honest intent to make a profit. Factors that can prove this intent include:

* Conducting the activity in a business-like manner by keeping good records and searching for profit-making strategies.

* Having expertise in the activity or hiring advisers who do.

* Spending enough time to justify the notion that the activity is a business and not just a hobby.

* Expectation of asset appreciation (this is why the IRS will almost never claim that owning rental real estate is a hobby even when tax losses are incurred for many years).

* Success in other ventures, which indicates business acumen.

* Losses caused by unusual events and plain bad luck as opposed to foreseeable ongoing losses that nobody except a hobbyist would be willing to accept.

* Financial status: rich folks can afford to absorb ongoing losses (which may indicate a hobby) while ordinary folks are usually trying to make a buck (which indicates a business).

* Elements of personal pleasure: running a charter fishing boat is lots more fun than draining septic tanks, so the IRS is far more likely to claim the former is a hobby if losses start showing up on your returns.

The bottom line: Business status is good for deducting losses; hobby status is bad. You'll be happy to hear that court decisions have declared drag racing, sailboat racing and hosting fishing tournaments (among many other seemingly pleasurable activities) to be businesses instead of hobbies after evaluating the aforementioned factors. For more information on the tax implications of business versus hobby status, check out IRS Publication 535 (Business Expenses) at www.irs.gov.