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Business? Hobby? What's the difference?

When you have your taxes done at the end of each year an important factor is whether you had income from a business venture or a hobby.  Most people wonder why it matters what it's called; income is income, right? Not exactly, if you are engaged in a hobby that generates revenue, that is, "cash in;" your expenses incurred to earn that revenue may not be fully deductible for tax purposes.  Therefore you may have income even though you didn't actually generate any money after expenses.  With a hobby, expenses can only be deducted as miscellaneous itemized deductions up to the amount of revenue generated.  Miscellaneous itemized deductions are subject to 2% of adjusted gross income, meaning that the deductible amount is only the dollars greater than 2% of your overall income for the year. If your activity is a business, then you are allowed to deduct expenses that can create a loss used to reduce your total income and tax liability. According to the IRS, an activity is presumed to be a business if it reports a profit in at least three out of five years. If it does not you may need to prove to the IRS that you are engaging in an activity with a profit motive i.e. the desire to make money, and that you are conducting your activity in a businesslike manner.  And even if your activity has met the three-out-of-five years profits test, the IRS can challenge the profit motive if the facts indicate that the activity is not a business. For example, if the business makes relatively small profit compared to its losses.

Here are some questions to ask yourself to determine if your activity is a business:

  1. Does the time and effort I have put into this venture indicate that I am making a good faith effort to make a profit?
  2. Do I depend on the income from this venture?
  3. Are my losses (if any) due to circumstances outside of my control, or because of start-up costs?
  4. Do I or my advisors have the knowledge necessary to carry out this activity?
  5. Have I adjusted my operational methods to improve the chance of profitability?
  6. How many elements of personal pleasure or recreation does this venture involve?

These questions may be among those asked by the IRS.

Some ways in which you can make sure that you are deducting your losses appropriately are to run your venture in a strictly businesslike manner including being active in the venture, doing the appropriate research, asking for help from experts or professionals and avoiding bad business practices such as co-mingling funds.

If you have any questions on business versus hobby rules or on how to improve your business practices, give us a call; we aren't just tax professionals, we are business advisors as well.

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