Is Your Business Considered a Hobby by the IRS?

Very frequently I get people asking me clarification on IRS rules that they heard from a friend, neighbor or colleague.  Usually some part of the statement is true, but there is always more to the story or it may not apply to that person’s specific situation.  How many of you heard the statement, “You can’t deduct a loss from business if it is more than 3 out of 5 years.”?  Well, this is not the entire truth.

A person that conducts an activity for profit is allowed to deduct the expenses that are ordinary and necessary in that industry.  If the expenses exceed the income, the amount can offset other income such as wages, interest or dividends.  However, if your activity is a hobby, you cannot reduce your other income by the losses.

When your losses exceed the 3 year rule, the burden of proof now shifts to the taxpayer to prove the activity is a for-profit business.  Here are some factors to consider:

• The manner that you carry on the activity
• The expertise of the taxpayer in this industry
• The time and effort spent in the activity
• The taxpayers history and success in this industry
• The elements of personal pleasure or recreation

Here are some ways to ensure your for-profit business is not considered as a hobby:

1. Keep thorough and business like books
2. Use a separate business checking account
3. Log any personal use on assets, such as a camera
4. Research trends in similar businesses
5. Obtain insurance, registrations, certifications, licenses needed for that type of industry
6. Maintain a second phone listing for business
7. Document evaluations of your operation to attempt to improve the business’s profitability
8. Develop a written business plan and update it annually
9. Keep a detailed calendar of your business activities

Pretend that you are a personal chef.  You also have a W-2 job with a local city.  You earn about $200-300 in income; however, your expenses are much more than that.  Come to find out, you host dinner parties at your home and want to write off the food, subscription to cooking magazines and seeds for your home garden.  Is this a business or a hobby?

If you are in doubt, just imagine yourself in front of an auditor explaining your specific situation.  If it “feels” like the story above, it may not fly with the auditor, but that does not mean it is not a true business.  What you need to do is plan and strategize.  What can you do today to prove that you are a for-profit business?

Know the rules and then step out in confidence.  And, don’t get tax advice from a friend because it might not be the whole truth!  Consult your tax preparer to confirm your specific situation qualifies!