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.
