The old and fast rules to determine whether your business activity is deemed a hobby in the eyes of the IRS have been replaced by guidelines. Here is what you need to know as you wrap up your business year.
You’ve loved dogs all your life so you decide to breed them and start a dog training business. Is this a business in the eyes of the IRS or a hobby? Knowing what the IRS is looking for and properly positioning your small business can save taxes and headaches if you are ever questioned by the IRS.
Why should you care?
If your activity is a business your income can be reduced by all your qualified business expenses even if it results in a loss. If your activity is a deemed a hobby, no losses are allowed on your tax return. Furthermore, your hobby expenses are treated as miscellaneous itemized deductions and do not count until they (and other miscellaneous expenses) surpass 2% of your income.
Tips to make it a clear business
Here are some simple tips to ensure full deductibility of your expenses against your business income.
- Profit motive. You must show that you intend to make a profit with your activity. The old rule of thumb was to show a profit at least three out of the past five consecutive years to safely qualify your activity as a small business. But this is no longer the case. Although more difficult to substantiate, you can show profit motive without ever showing a profit by your ongoing activities around the business.
- Active participation. You need to be actively involved in your pursuit for success. If you simply invest money in the dog business, but are never there to care for them or give lessons, you will have a hard time justifying the business nature of the activity.
- Be professional. Businesses have separate checkbooks, business cards and stationery. They have financial statements and show the same disciplines one would find in a “for profit” venture of the same type of activity you are pursuing.
- Pleasure factor management. If your business has a large enjoyment factor, you will need to be even more cautious about having proper records. Ideally the pleasure factor is secondary to running your business. If you claim to be a golf pro giving lessons, but then spend all your time playing golf, you will have a hard time justifying the activity as a true business.
- Have multiple customers. If you only have one or two customers, who also happen to be relatives, your activity may be deemed a hobby. Having a number of customers, even without profits, can make all the difference in allowing for expense deductions.
- Showing profit motive without profits – Part II. How else can you show profit motive when no profit is to be found? Advertising is one way to do this. Keep copies of all ads trying to drum up business. Keep a daily diary of business activities, noting who you meet and for what purpose. Create and keep sample product, even if it is not yet sold.
- Understand your risk. There are certain business types that are under the IRS microscope when it comes to hobbies. Key among these are multi-level marketing businesses like Amway, Tupperware and Avon. It also includes the thousands of part-time sellers of goods on internet sites like e-bay. If you are in one of these business activities you will need to prove the business nature of your involvement and be prepared to be challenged.
Wondering if your business activity may be considered a hobby? Review this checklist. The more yes answers, the better your chances of defending your position.
- Conducted activity in business-like manner?
- Have expertise in your activity?
- Put time and effort into the activity?
- History of income/profits?
- Have had prior success in a similar activity?
- Is there a low element of pleasure/recreation involved?
- Are there appreciating assets or an expectation that there will be?
Remember, having a business activity reclassified as a hobby can mean a big tax bite at tax time. But by keeping proper records and pro-actively knowing the pitfalls, you can avoid most problems.