We all have hobbies. But at what point does a hobby become a business? Of course, there’s the idea that “if you get paid for it, it’s more than a hobby.” For example, I may practice flamenco every evening until I’m red in the face, but that’s still just a hobby until I start booking gigs at tapas parties. At that point, I run a flamenco business, right?
Maybe not. And the distinction between a hobby and a business is of particular interest to the IRS, as it affects what you can deduct from your income on tax day. The problem is, there’s no hard-and-fast rule as to when something is a hobby, or when it’s a business. However, one thing is clear: If the IRS determines your flamenco company, Sevilla Sunrise, is just a hobby and not a bona fide business, you can only deduct business expenses up to what you made in profits.
For example, if you spent $500 on castanets and a fancy outfit but only made $100 from dancing, you can only deduct $100 as an expense. Basically, you can’t claim losses beyond what you brought in. And if you get audited and it’s determined that you didn’t comply with these rules, then you could be facing various penalties along with having to pay back what you claimed.
So, what can you do help show John Law that you’re in fact a business? Let’s take a look. (Bear in mind that I’m not a tax attorney, so the following is merely for your consideration and should be taken with a grain of salt.
What does the IRS Take Into Account?
According to its website, the IRS takes the following things into consideration when making a determination:
- “Does the time and effort put into the activity indicate an intention to make a profit?
- Does the taxpayer depend on income from the activity?
- If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
- Has the taxpayer changed methods of operation to improve profitability?
- Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
- Has the taxpayer made a profit in similar activities in the past?
- Does the activity make a profit in some years?”
The agency cap the list off by saying that “the IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year — at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses.”
(The horse thing made me have to read it twice too.) Also, a for-profit endeavor is considered as such “if it is carried on with the reasonable expectation of earning a profit.”
Clearly, not every business will turn a profit in its early stages. But the IRS is not into “hobby losses,” which is when someone tries to deduct an expense for something they deem to be a hobby. In these cases, individuals must itemize their expenses on a Schedule A tax form. For most small businesses, deductions are recorded using a Schedule C.
So, it’s pretty clear that you want to prove your business is a for-profit enterprise with the intention to actually make money. Luckily, there are a number of things you can do to prove this intention, even if you’re not yet raking in the dough.
For one, you can open up a separate bank account and run all your business transactions through it (cough, Seed). We went through the other reasons to do this in a recent post.
Other best practices include:
- Keeping good financial records
- Registering your business as an LLC or other kind of partnership.
- Following local, state, and federal laws.
- Performing marketing and advertising activities
- Just acting like a business in general. Keep up with your website, have dedicated email addresses, etc.
Luckily, most of these things are activities a healthy fledgling business is already doing. That is, in addition to spending painstaking hours in front of a mirror, mercilessly practicing mysterious flamenco moves and daydreaming about where to spend all your cash.
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