What Is Profit Motive?
Profit motive is the intent to achieve monetary gain in a project, transaction, or material endeavor. Profit motive can also be construed as the underlying reason why a taxpayer or company participates in business activities of any kind.
In economic thought, Adam Smith identified the profit motive in his book, The Wealth of Nations, as the human propensity to truck, barter, and trade.
- The profit motive refers to an individual's drive to undertake activities that will yield net economic gain.
- Because of the profit motive, people are induced to invent, innovate, and take risks that they may not otherwise.
- Profit motive is also a technical term used by taxing authorities to establish a basis for levying taxes.
Understanding the Profit Motive
Economic thinkers have long asked: why do people do the things that they do? Why do some become bakers, some butchers, and others candlestick makers? Why do people take the risk of starting a business or innovating? The answers to these can boil down to an individual's profit motive - the drive to undertake some activity with the hope and expectation of being wealthier for doing so.
Because of this motive to profit, Adam Smith famously conceived of the 'invisible hand', which suggests that self-interested, profit-seeking individuals are more broadly beneficial to society on net than those who use the political process to improve society. While accurate, this interpretation ignores the process that makes it possible for capitalism to produce wealth so efficiently.
The relevance of the profit motive has come under scrutiny in recent times, as economists and thinkers argue that people, in reality, are social and not simply cold, calculating profit maximizers.
Establishing Profit Motive and Taxation
According to the Internal Revenue Service (IRS), taxpayers may deduct ordinary and necessary expenses for conducting a trade or business. An ordinary expense is an expense that is common and accepted in the taxpayer’s trade or business. A necessary expense is one that is appropriate for the business. Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit, that is, a profit motive.
Profit motive must be assessed for some transactions in order to determine the deductibility of any expenses involved. For taxpayers who participate in rental activities, for example, profit motive must be determined in order to claim rental expenses. The IRS may try to prevent a taxpayer from claiming rental losses if a profit motive cannot be proved. A profit motive can be established by proving that a profit was realized in at least three out of the last five years. Activities that consist primarily of breeding, showing, training or racing horses, must show profit for at least two of the last seven years.
Profit motive is also what separates a hobby from a business in the eyes of the IRS – losses from a hobby are non-deductible because there is no intent to make real economic profit. Since hobbies are activities participated in for self-gratification, losses incurred from engaging in these activities cannot be used to offset other income. Hobby income, even if occasional, must be reported as “ordinary income” on Form 1040. Deductions for hobby activities can only be claimed as itemized deductions on Schedule A. Furthermore, since hobby expenses are considered "miscellaneous itemized deductions," a taxpayer can deduct only the amount that exceeds two percent of his or her adjusted gross income (AGI).
For a business start-up that has not existed for up to three years, the business owner may take two approaches to establish a motive to make profit. One way is to qualify for a presumption that s/he has a profit motive, which means that s/he doesn't have to show a profit for the first two years of operations. If a business qualifies for this presumption, it means that the IRS (not the business owner) has the burden of proving that your business is a hobby, if the issue comes up in an audit.
Another way a business owner can establish profit motive is by showing that s/he operated for profit under the IRS's nine criteria profit motive test. Business owners that don’t qualify for the presumption can use this method. The nine critical factors used by the IRS to determine whether a business is run for profit or as a hobby are:
- Whether the activity is conducted in a business-like manner
- The expertise of the taxpayer or his advisers
- Time and effort spent in operating the business
- The likelihood that the business assets will appreciate in value
- Past success of the taxpayer in engaging in a similar (or dissimilar) venture
- History of income or loss of the activity
- Amount of any occasional profits earned
- Taxpayer’s financial status
- Any elements of personal pleasure or recreation