No matter the legal form of your business, the IRS may challenge your assertion that you are engaged in a business rather than a hobby. There is a significant difference in how the tax code treats hobby income and expenses versus business income and expenses. The IRS estimates that incorrect deductions of hobby expenses account for an estimated $30 billion per year in unpaid taxes due to overstated adjustments, deductions, exemptions and credits. If you tell the IRS you are engaged in a business you had better be able to “walk the walk” and prove it.
Generally, an activity qualifies as a business if it has a profit motive. If not, the activity is subject to the hobby loss rules which state that deductible expenses are limited to the amount of income generated. Further, the expenses must exceed two percent of adjusted gross income before providing any tax benefit. Losses are unable to offset a taxpayer’s other income and a portion of a hobby income may be subject to tax.
The IRS and the courts have provided the following factors to be considered in determining a profit motive.
Do you have a business plan? Business plans provide directions to the business owner, investors, bankers and the IRS. You should have a plan that projects an overall profit and reasonably predicts when you expect this profit to occur.
How do you run your business? Your activity should be conducted in a business-like manner. Your business should maintain a separate bank account, keep a separate set of books, and act like similar profitable businesses. You should have a yearly income statement and balance sheet, advertise your business, and have business cards and stationery. If you conduct your business like other successful people in the same industry you have a strong argument.
Do you have expertise in the field? A business operator should have extensive knowledge of his or her chosen profession or activity. This can be demonstrated by seeking advice from experts in your area and studying accepted business methods. Prior business experience with a similar product or service can also make a difference to the IRS.
Do you expend substantial time and effort? Devoting time to your business indicates intention to make a profit. Even if you have another job, using your free time to pursue this activity indicates an honest intention on making a profit. Document your time spent in order to better support your for-profit intent.
Have you changed your operating methods to improve profitability? If you have incurred losses in the past, documenting your efforts to improve profitability would lend credence to your assertion of a for-profit business motivation.
Will your business assets appreciate? If you expect assets used in your activity—such as land—to appreciate in value, IRS regulations say that appreciation may be used in lieu of current profits to indicate a profit motive for the business.
What is your past record in business? Even when your present business is unprofitable, if you have been able to convert other businesses in the past from unprofitable to profitable, this would be considered a factor in determining your profit motivation in your current business.
What is your history of income or losses? Losses in your business alone are not indicative that you are really engaged in a hobby. However, a long series of losses may draw the attention of the IRS, whereas sustained earnings indicate a business run for profit.
What are your relative profits and losses? According to the IRS, “The amount of profits in relation to the amount of losses incurred, and the relation to the amount of taxpayer’s investment and the value of the assets used in the activity, may provide useful criteria in determining the taxpayer’s intent.” However, the presumed profit motive in the IRS Regulations states that if an activity has a net income for three or more of the last five years then the activity is generally presumed to be for-profit.
What are your other sources of income? The IRS considers whether you have other sources of income. Having other income sources does not necessarily preclude your activity from being considered profit-motivated. The amount of time and effort you expend on your business may determine whether or not the business is considered to be operated for-profit.
Do you have recreation or “personal motives” for the activity? Activities that have recreational appeal and sustained continued losses may be more difficult to establish as for-profit activities rather than hobbies. For example, if you are serving as a guide for tour groups, it could be construed that you are using the activity to cover the cost of your travel expenses. On the contrary, if you are providing janitorial services such as scrubbing bathrooms and mopping floors, there is very little recreational appeal.
Using the guidelines above can help strengthen your case with the IRS for running a profit-motivated business rather than being engaged in a hobby.