A hobby can be a blast, but not when the IRS gets involved. You are waving a big red flag at the IRS if your business claims a net loss for too many years or it fails to meet other requirements. Why is this? The IRS may classify your business as a hobby if you can’t prove a profit motive. If you are operating a business and incurring losses, the last thing you want is for the IRS to determine that your business is a hobby.
WHAT’S SO BAD ABOUT HOBBIES?
“Hobby” is a dirty word in the tax world. Hobby loss rules are some of the least taxpayer-friendly rules in the tax code. Income from a hobby is reported as gross income. However, you can only deduct your hobby expenses up to the amount of your hobby income. Adding salt to the wound, you must be able to itemize deductions on your tax return in order to deduct hobby expenses. It gets worse – you get a haircut on the hobby expenses since they are reduced by 2 percent of your adjusted gross income.
KNOW THESE NINE FACTORS
The IRS expects that you are in business to make a profit. If not, they may conclude you are deducting your hobby. Here are nine factors that the IRS is looking at:
The business-like manner in which you carry on the activity.
The expertise of you or your advisers.
The time and effort you devote to the activity.
The expectation that business assets may appreciate in value.
Your success in carrying on similar and dissimilar activities.
Your history of income or losses with respect to the activity.
The amount of occasional profits, if any, which are earned.
Your dependence of income from the activity.
The elements of personal pleasure or recreation.
While enjoying the activity is rarely a critical factor in itself, it can be a tip-off. Auto racing losses, for example, are certain to wave the red flag instead of the checkered flag if you also have a well-paying day job.
PREVENTING RECLASSIFICATION AS A HOBBY
When the IRS comes knocking and asks for proof that your business is legitimate, they want “businesslike” documentation. The more ways you can prove your profit motive, the better. Good records are one of the most important factors, including:
A business plan – even if it’s a brief one.
Budgets and projections of revenue and expenses (monthly is best if you have significant losses).
A ledger of revenues and expenses – QuickBooks or similar is smart.
Documentation of problems beyond your control.
Record of prospective clients and team members.
CONSULT WITH BUSINESS ADVISERS
If your business is losing money year after year, the IRS expects that you will seek the advice of professionals to help turn business around. If you consult with a professional, be sure to document the meetings and advice.
KEEP A TIME JOURNAL
A record of your time and effort can be an indicator of your intent to make a profit. Record the time you spend on ways to improve business. It will help defend the point that your activity is a business and not a hobby.
THE BOTTOM LINE
If your business has lost money for multiple years, you may be on the radar. It takes a bit more work to build up a strong defense against the hobby loss rules. Make sure you’ve done all you can to protect your tax deductions.
Chris Thornburgh is a CPA and partner at Brown Armstrong Accountancy Corp. Contact her at email@example.com or 324-4971.