Many small business incur losses over the first few years of operations. What you do to make sure that these deductions survive an audit is critical. The reason is that that the IRS limits deductions for anything it considers a hobby to the amount of income it generates. The IRS will initially consider the business a hobby if it does not make a profit.
If in fact you have a hobby, the effect on your tax return is disastrous. The income is reported as other income on Form 1040. The deductions are considered personal and must exceed 2% of your adjusted gross income as part of your total itemized deductions, which then must exceed the standard deduction. What this means for many who fall under this trap, is that the expenses wind up being not deductible.
The IRS looks at many things to make their determination but generally rely on nine factors to determine if you have a business or a hobby.
- Is the entity operated in a businesslike manner – The taxpayer can establish this by maintaining separate personal and business bank accounts, keeping records and books, and acting like similar profitable, operational entities.
- The expertise of the owner – A business operator should have extensive knowledge of his or her profession or activity, showing that he or she has studied accepted business methods and sought advice from experts.
- The amount of time spent in the business – a substantial time and effort must be made in carrying out the activity with the objective of making a profit.
- Appreciation of assets – assets used in an activity, such as real estate, may appreciate in value – this test is considered in lieu of current profits as long as it still exceed expenses.
- Past experience – if the taxpayer’s activity is currently unprofitable, it may be for-profit if the taxpayer has been able to convert other activities from unprofitable to profitable in the past, especially ones similar to the current activity.
- History of income or losses from the activity. The economy plays a big role in how much business as losses alone may not be conclusive. However, a long series of losses warrants consideration as does sustained profitable earnings. If an activity has gross income for three or more of the last five years that exceeds the deductions attributable to the activity, the activity generally is presumed to be for-profit.
- Relationship of profits and losses – the amount of profits in relation to the amount of losses incurred, and in relation to the amount of the taxpayer’s investment and the value of the assets used in the activity provides criteria in determining the taxpayer’s intent.
- Financial status – whether the taxpayer has other sources of income, although their presence does not preclude an activity from being considered for-profit.
- Is the activity recreational – if it involves personal motives, this may, with other factors, indicate lack of a profit motive. This especially applies to activities that many people consider as hobbies – photographers, artist, musicians, etc.
After reviewing the records and previous tax returns for an activity, it often can be determined whether the activity is a hobby or a for-profit activity based on these nine factors. However, taxpayers must understand that there is no single, defining pattern or factor that is conclusive of whether an activity is for-profit or a hobby, and all the facts and circumstances must be considered.
Adopted from The Tax Advisor July 1, 2013 author Robert Gard, CPA