Is the business a business or a hobby?
The IRS is stepping up efforts to prevent taxpayers from declaring losses on activities that are not run to make a profit. Research shows that incorrect deduction of hobby losses cost the government billions per year.
The Tax Rules
If your business is engaged in for profit, ordinary and necessary expenses are deductible from the income, and a taxable profit or a deductible loss might be created.
If your business is not engaged in for profit (hobby), income is taxed in total as other income, and expenses are limited to income received and deductible as miscellaneous itemized deductions if you itemize your deductions.
The Presumption of Profit
If a business is profitable in at least 3 of the last 5 years, including the present year, the IRS presumes it is engaged in for profit. If the business is engaged in breeding, training, showing or racing horses it needs to be profitable in 2 of the last 7 years to be presumed profitable.
Factors to Consider
With Congress and the IRS hot on reducing revenue losses, you should be aware that your unprofitable business could be reclassified as a hobby. To determine whether your business is a hobby, the IRS asks you to consider the following factors:
- Does the time and effort put into the activity show intention to make a profit?
- Do you depend on the income from the activity?
- Have you changed your methods of operation to improve profitability?
- Do you have the knowledge to make your business successful?
- Have you made a profit in the past?
- Can you expect a profit in the future? It would be wise to invest a little effort in growing your business to profitability.
Steps You Can Take
To be considered a business, your unprofitable endeavor has to look like a business. The following list of steps could help you run your business in a businesslike manner.
- Obtain a business license.
- Print business cards, stationery, and invoices.
- Open a separate bank account for the business.
- Keep a formal set of books.
- Document your business activities on an appointment calendar.
- Advertise your business.
- Join local business and professional groups to network your expertise.
- Write a business plan.