IRS Business vs Hobby Rules: Are You a Business?

Many great businesses have been built out of hobbies and other income producing activities.   Often these businesses start very small, as what some call "lifestyle" businesses that eventually create a little income.  Over time, the entrepreneur is able to transition from a few evenings and weekends to a
full-time business.  So, is your "business" a hobby or is your "hobby" a business?

You should know that the Internal Revenue Service is stepping up efforts to prevent taxpayers from deducting losses on activities that aren't genuine businesses run to make a profit. The problem is that it's not so easy to tell a budding business from a hobby.

Officials say new research shows taxpayer errors in this area are costing the government billions of dollars a year in unpaid taxes.  Thus, auditors are "on the lookout" for people trying to deduct losses from hobbies.  To underscore the agency's concern, the IRS recently issued a fact sheet that is aimed at "making sure that taxpayers know and abide by the rules."

How are you supposed to figure out whether your activity qualifies as a genuine for-profit business?  That can be exceptionally tricky.  The IRS says you should consider several factors.  Does the time and effort put into the activity indicate you intend to make a profit?  Do you and your advisers have the knowledge needed to carry on the activity as a successful business?

Another factor is whether you have made a profit in the past.  The IRS says it "presumes" an activity is indeed carried on for profit if you have made a profit during at least three of the past five tax years, including the current year. The rule is different -- at least two of the past seven years -- for activities that consist primarily of breeding, showing, training or racing horses.

There are other things you can do.  Obtain a business license.  This can go a long way in convincing everyone of your serious intentions about making a profit. It’s generally quite inexpensive to obtain one, and in most places, it’s the law anyway.  Also, go to the local print shop and have some stationary, business cards and invoices printed.  Opening a separate bank account and keeping separate records are also good ways to show that you’re regularly spending time working in your business.

The key is to be cautious and realistic on how you approach your business and make sure to keep very good records. Don't mix expenses and revenues that may create red flags. And keep good records, including a separate checking account for your fledgling business venture.  Finally, make sure you take advantage of
my tax expertise.  Ask questions.  Be proactive.  It’ll keep you out of trouble.