Is Your Small Business Really a Hobby?
The Internal Revenue Service (IRS) has several rules on small business deductions – designed to determine if you are managing a small business or a hobby.
According to the IRS, incorrect deductions and adjustments that are actually hobbies result in $30 billion in unpaid taxes. Taxpayers are able to deduct normal and necessary expenses for business, provided it meets the expenses meet business activities guidelines.
The #1 Question: Did Your Business Make a Profit?
Although there is no clear answer, in general your business is considered a hobby if you fail to turn a profit the last 3 out of 5 years. The IRS may audit you if you continue to claim business deductions with no profit.
Don’t panic if you’ve failed to make a profit. As with all businesses, make sure you maintain excellent accounting records.
If you are audited while running a legitimate business, you will need to address the following questions for the Internal Revenue Service:
- Do you carry on the activity in a businesslike manner?
Make sure you have records and transaction receipts. Personal and business funds should have separate accounts. How do you conduct business, maintain client records, and market your service or product?
- Does the time and effort put into the activity indicate an intention to make a profit?
There is a big difference between working on an activity every week compared to a few days a year. Be sure you can demonstrate the time and effort you’ve put into your business.
- Do you depend on income from the activity?
Does your livelihood depend on your business? If you have a full-time job you will need to make sure you can clearly demonstrate how the profitability affects you.
- If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
When the economy tanked a few years ago, many small business owners saw a significant decline in profitability due to circumstances beyond their control. Other items like natural disasters and supply shortages can create loss.
- Have you changed methods of operation to improve profitability?
If you realize you’re not making a profit and continue to do the same things, you may have a hobby and not a business. Be able to demonstrate how you have made changes to your business operations to increase profits.
- Do you have the knowledge needed to carry on the activity as a successful business?
Do you know enough about your industry to be successful? As much as you may love France, you can’t be a French translator if you aren’t fluent in French.
- Have you made a profit in similar activities in the past?
Have you ever made a profit? The IRS recognizes that things happen, but if you’ve claimed a loss for the past 5 years, there is clearly a problem. Do you foresee a profit in the future? If not, it’s probably a hobby.
NOTE: This article should not be considered legal or tax advice. Consult a legal or tax specialist for more information.