Is your “business” not really a business, but just a hobby in the eyes of the IRS?
At what point is the work you perform deemed to constitute a “business” on your tax returns? It depends, but I can assure you that you would rather have the IRS treat your activity as a business and not hobby.
An individual conducting an activity as a for-profit business is allowed to deduct expenses that are ordinary and necessary in carrying on the trade or business. If expenses exceed income, the loss is deductible against other forms of income, such as wages, interest, dividends, etc. If the loss is attributable to an activity classified as a hobby, however, it is not deductible against other forms of income.
As a general rule, the IRS will consider your activity to be a for-profit business if you have earned a profit in at least three of the preceding five years. If you do not satisfy this rule, all hope is not lost. In the right circumstances, taxpayers can establish a “profit motive” despite persistent losses. To support a for-profit business motive, taxpayers should do the following:
- Keep thorough and business-like records.
- Keep business and personal aspects separate. For example, use a separate business checking account, track business vs. personal use of assets, etc.
- Actively advertise your business.
- Obtain the insurance, registration, certification and license required for the business.
- Document periodic evaluations of operations to demonstrate an attempt to improve profitability.
- Develop a written business plan and update it annually.
The issue of business vs. hobby continues to be a source of many disputes between taxpayers and the IRS, and for good reason. The distinction between a for-profit business and a hobby can result in serious tax dollars either being saved or lost. Talk with your CPA to make sure your activity is properly classified as either a business or a hobby.