Determining whether an activity is engaged in for profit can be very subjective and therefore the IRS offers a safe harbor which allows flexibility that normally would not be permitted. This safe harbor basically establishes a presumption that the activity is a for-profit endeavor. If the taxpayer wishes to meet the safe harbor, they must show that there activity generated a profit in at least three of the five years ending with the tax year in question.
Once the safe harbor is met, the burden of proof will shift to the IRS in providing evidence that the activity is in fact not conducted with a profit motive. If the safe harbor is not met, the taxpayer must use subjective factors provided in Reg. 1.183-2(b) to prove that the activity is conducted with intent to earn a profit.
In some situations a taxpayer may wish to extend the determination on whether the safe harbor applies to their activity. By filing Form 5213 (Election to Postpone Determination as to whether the Presumption Applies That an Activity is Engaged in for Profit) the taxpayer can delay the determination until the close of the fourth tax year after the tax year in which the taxpayer first engages in the activity.
One drawback to filing Form 5213 is that it alerts the IRS to a possible Section 183 issue and automatically extends the statute of limitations for assessing deficiencies attributable to the activity during the determination period. For this reason alone, Form 5213 is usually filed only after the IRS has notified the taxpayer of proposed disallowed deductions relating to a possible hobby activity.