If the IRS thinks you have a hobby instead of a business, it could cost you a lot in taxes.
If the money you spend more money on your business than you earn, your business incurs a loss. However, if you keep reporting losses year after year, you need to be very concerned about running into trouble due to the “hobby loss rule.” This rule could cost you a fortune in additional income taxes.
The IRS created the hobby loss rule to prevent taxpayers from repeatedly deducting losses. If a business shows a loss for three years out of five, then the IRS considers the activity to be a hobby. A venture is considered a business only if you engage in it to make a profit.
If you keep incurring losses and can’t satisfy the profit test, you must be prepared to convince the IRS that your business is not a hobby in case you’re audited--and there is a good chance you will be audited.
How do you prove you are seriously involved in the business for money making purposes? The IRS looks closely at the manner in which the activity is carried out and there are nine regulatory guidelines:
1. The manner in which the taxpayer carries on the activity. Are there complete accurate books, a budget, and separate accounts?
2. The expertise of the taxpayer or his advisers. Did the taxpayer study the activities business practices? Did they consult with experts?
3. The time and effort expended by the taxpayer in carrying on the activity. Do they devote a lot of time to the business particularly in comparison to other employment?
4. The taxpayer’s history of income or losses with respect to the activity. Has the taxpayer become profitable in a reasonable amount of time?
5. The expectation that the assets used in the activity may appreciate in value. Is the plan to generate profits through asset appreciation?
6. The success of the taxpayer in carrying on similar or dissimilar activities. Have they been able to convert the activity from unprofitable to profitable?
7. The financial status of the taxpayer. Does the taxpayer have other income sources that are being offset by the losses of the activity?
8. The amount of occasional profits. Consistent loss is a red flag.
9. Does the activity lack elements of personal pleasure or recreation? If the activity has large personal elements it is indicative of a hobby.
If the IRS deems a business as a hobby, the income is reported as "other income" on Form 1040. But “Hobby Expenses” are only deductible if you itemize deductions. They fall under “miscellaneous deductions" and you can only deduct the portion that, along with any other miscellaneous deductions, exceeds 2% of your adjusted gross income. Depending on your particular tax circumstances this can result in all income from the hobby being taxable income with no offsetting deduction for hobby expenses.