How the IRS Decides Whether You Have a Business or a Hobby

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As the end of the year approaches, and tax season rears its head, it’s important to start figuring out what deductions and credits you are eligible for.

Many consumers are excited to learn that they can take deductions for hobbies as well as for businesses.

However, what is allowed when it comes to these tax deductions depends a great deal on whether the IRS thinks you have a legitimate business, or whether what you are doing is really a hobby.

Tax Deductions: Business vs. Hobby


When you have a legitimate business, you can deduct your business expenses from your business income — and then deduct any additional losses from other income.

So, if your home business makes $5,000 this year, but you have spent $6,000 to keep it going, you can deduct those losses.  Not only do you end up reporting no income for your business, but you also get to deduct the $1,000 loss from other income you have.

A hobby is a different matter.

While you can deduct the expenses that you incur while pursuing your hobby, you can only use them to offset any income from your hobby, and you can’t deduct losses from other income.

Perhaps you have a fishing hobby.  You spend $500 for the year buying a new pole, as well as purchasing bait and tackle, and other supplies, including waders.  Sometimes, you enjoy tying flies.  You sell some of the flies you aren’t using for a total of $200.

You can offset the $200 in income made as a result of your hobby with some of your expenses.  However, you will still have a $300 loss.  Since you have a hobby, you can only deduct amounts up to your income.

You can’t take your loss and apply it to other income, like you can with a business loss.

How the IRS Decides that You Have a Hobby

business versus hobby

Just because you made some money it doesn’t mean you have a business in the eyes of the IRS. They might just see a hobby.

One of the simplest methods for determining whether or not your activity is likely to be considered a hobby is your profitability.

The IRS likes to see a business show a profit in any three of the past five years.  So, if you keep claiming losses on your taxes, particularly on your Schedule C, without showing years of profitability, your return will raise red flags and the IRS could decide that you have a hobby — not a business.

Interestingly, these rules also apply to profits and losses from farming.

You will have to fill out a Schedule F, and if you show losses in more than two of the last five years, your farming business could be relegated to the status of hobby.  Among the exceptions to this rule is horse breeding.  You only have to show a profit in two of the last seven years to be considered a business.

Before you try to say that your hobby is a business, consider this rule.  If you aren’t showing some profits, the IRS will classify your activity as a hobby — no matter how you view it.

How to Convince the IRS that You Have a Legitimate Business

You will want to convince the IRS that you have an actual business if you want to deduct your losses from other income.

Even if you don’t meet the profitability rule, you can still convince the IRS to view your activity as a business.  Here is what you need to show in order to get the IRS to regard your business as a legitimate enterprise:

Evidence that you are working to turn a profit

You need to show that you are working toward turning a profit at some point.  If you can provide proof that your idea will eventually result in regular profits down the road, the IRS might waive the profitability rule.  This means that you need to have a solid marketing plan, as well as a business plan.

Create a business plan based on a profitable business model

Show the IRS a business plan, based on a business model that might actually work.  You need to indicate that there is an end in sight for all the losses you are claiming.

It doesn’t hurt to actually organize your activity in an official business organization, such as an S-Corp or LLC.

Managerial ability

Prove that you have some expertise in your field, or that you have some skills and experience related to managing.  If you are a legit manager, the IRS is more inclined to see your activity as a business.

Your investment

If you put in your own time and money, the IRS might decide that you are running an actual business.  You need to show that you are putting on the line if you want the IRS to decide that you aren’t just looking for an excuse to deduct your hobby losses.

Finally

With a little planning and effort, you can turn your hobby into a business — one that legitimately deducts losses from various sources of income.

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Published or updated April 15, 2013.

Comments

  1. I didn’t think I’d be profitable in my first year with my side gig but it does look like I’ll turn a profit! I’m glad too because having a business is a great thing for taxes. Lots of opportunities.

  2. Miranda, thanks for the excellent post and clarification! I didn’t realize you could deduct losses if the IRS considers you a business. Hmmm…that is definitely something to take into consideration!

  3. In the end, you do have to be honest with the IRS. But if you really are trying to make a go of something, then just make sure you claim fewer expenses than payments for two out of five years.

    You can make up to about $500 without being subject to self-employment tax. Though you’ll want to check Schedule SE instructions to be sure about that.

  4. Ti Roberts says:

    This is a very informative post Miranda. I’m thoroughly enjoying seeing your posts over at BizSugar.com. You’ve definitely shared some useful information that I’ll definitely be taking into consideration. Thanks again sharing this info with us. I appreciate it!

    Ti

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