Can My Hobby Be A Business?
By Steven A. Leahy
Do you use deductions for a side business to reduce your tax liability? The IRS makes a distinction between business activity and activity that is a hobby, therefore not a business activity. If the activity qualifies as a business, the taxpayer can deduct ordinary and necessary expenses used to conduct that business. However, if the activity is determined to be a hobby, losses from the activity cannot be used to offset other income.
Most side businesses are undertaken because the taxpayer enjoys the activity – being allowed to deduct the expenses for that activity is just a bonus. The best way to qualify your hobby as a business is to earn a profit. Generally, if an activity is undertaken with a reasonable expectation of earning a profit, it qualifies as a business. The rule of thumb is – if the activity makes a profit during at least three of the last five years, including the current year, the activity is business activity.
This rule is not hard and fast. For example, a documentary filmmaker – who lost money six years in a row, was permitted to deduct hundreds of thousands of dollars in film making expenses against her income as an attorney. Tax Judge Kroupa recognized that some industries have longer start up periods than others, and the rule of thumb doesn’t account for those industries.
If you haven’t made a profit, here are some things you can do to demonstrate your intentions that this activity is for profit, rather than just for fun:
First, offer evidence that you expect to make a profit in the future. As in the documentary filmmaker case, losses as a result of a slow start-up may be deductible if you can show that a profit in the future is possible.
Next, expend time and effort into the activity. The more time and effort you demonstrate, the more likely the IRS will agree that the activity is a business. For example, you should document the time you spend on the activity, open a separate bank account, keep accurate records, advertise the business, and comply with local, state and federal business requirements (i.e. permits, licensees, etc.). All of these efforts demonstrate your intentions to make the activity profitable.
Finally, if the activity is not profitable, work on making it profitable. You can do this by changing the method of operations to attempt to make the activity profitable, seeking help from an expert to learn how to make the activity profitable, demonstrate an expertise in the activity – experts generally command a higher price.
There is a Tax Court case involving a track coach. The coach lost money for eight years, and the IRS denied his deductions under section 183 of the tax code “activities not entered into for profit.” The Tax Court looked at his attempts to make his activity profitable, including those mentioned in this article, and decided his activities were intended to make a profit.
The best time to present these arguments is at the audit. However, if a deficiency is assessed, the fight need not be over. So, if you are under audit, or have already had a deficiency assessed based on disallowed expenses for activities not entered into for profit, you should work with a local law firm that will fight the IRS findings on your behalf. Better, you should give me a call – Opem Tax Resolutions & The Law Office of Steven A. Leahy, PC (312) 664-6649. I want to help! Call NOW to set up your FREE Consultation.