Businesses can deduct most of the costs of doing business even if it shows a loss on the tax return. If a taxpayer has a hobby that generates income, direct expenses can also be deducted. This is where the similarity ends. A hobby cannot lose more than gross sales. So, what distinguishes a business from a hobby?
According to the IRS, the business’ purpose is to make a profit. Hobbies do not have a profit motivation. The service gives a list of nine factors to help the taxpayer consider in defining the activity. Each of these items is subjective in nature.
Let’s explore these nine factors.
- Whether the activity is conducted like a business. Does the taxpayer have complete records.
Not all businesses have complete records, but if the business owner(s) have records, this test may be passed.
2. Whether the taxpayer puts in both time and effort to make the business profitable.
3. Whether the taxpayer depends on the income from this activity for personal expenses.
4. Whether any losses are due to circumstances beyond the taxpayer’s control or are normal for a startup phase of the business.
5. Whether the business will change procedures to improve the chances of profitability.
This is an interesting test because some businesses don’t have a lot flexibility in the way they do their primary activity, but there are generally ancillary activities that can be changed, such as changes in marketing or sources of materials.
6. Whether the owner and their advisors have the skillset to perform the tasks efficiently.
7. Whether the taxpayer has a track record for making money in this industry in the past.
This does not mean that starting a business in an industry with no experience disqualifies the taxpayer. The owner will have to lean on the other evaluation points.
8. Whether the business shows a profit in a few years, (generally 3 of the last 5), and how much profit is being made.
9. Whether the taxpayers can expect to make a future profit from asset appreciation.
This only applies if the business has assets. I service based business such as accounting would not necessarily have appreciable assets.
The business does not have to pass all nine tests. However, the more tests passed, the stronger the case. The most important test is profitability. It is extremely hard to defend a claim of an activity being a business if there is no apparent path to profit.
Some might ask, “So what?” The cost to the taxpayer could be audits and disallowed deductions. If a taxpayer has shown a business loss for several years, by declaring the activity a hobby, the IRS can go back three years, disallow many or most of the business deductions causing new taxes due with associated penalties and interest.
To avoid such a problem, focus on the motivation for the activity. Is the goal to make a living from this activity or is it a fun thing to do for a little extra money on the weekend? Are you willing to put in the time and effort to build the business?
If the motivation is there, but the problem is that profits are not growing, it is time to call in qualified expertise. The first expert to hire is a small business accountant. We know how to isolate expenses and show the business owner how to judge the profitability of a course of action.
Do What You Do Well and Delegate Everything else to Someone Else.