Are you running a business? Or just having fun with a hobby?
The IRS has strict rules for determining the difference between a business and a hobby for tax purposes. While expenses incurred to conduct a business are deductible, expenses incurred for a hobby may not be, causing your taxes to increase.
A person that conducts an activity for profit is allowed to deduct the expenses that are ordinary and necessary in that industry. If the expenses exceed the income, a loss is incurred. This loss can offset other income such as wages, interest or dividends.
However, if your activity is determined to be a hobby for IRS purposes, you cannot reduce your wages, interest or dividends by any losses.
When you have losses for three years in a row, you must be able to prove to the IRS that your activity is truly a business and not a hobby.
The IRS will consider the following when evaluating your business/hobby:
- The manner that you carry on the activity
- The expertise of the taxpayer in this industry as well as the taxpayer’s history and success in this industry
- The time and effort spent in the activity and whether the taxpayer depends on the income for their livelihood
- The elements of personal pleasure or recreation
Even if you have losses, there is a lot you can do to ensure your business is not considered a hobby. Here are some ideas to implement.
- Develop a written business plan and update it annually. Show how you plan to convert your losses into gains.
- Set up a separate business bank account and credit card account(s), and use them only for business purposes.
- Keep thorough and professional books.
- Obtain insurance, registrations, certifications, and licenses needed for that type of industry.
- Maintain a second phone listing for business.
- Keep a detailed calendar of your business activities. Record time spent on your business.
- Document evaluations of your operation to attempt to improve the business’s profitability.
- Research trends in similar businesses.
- Log any personal use on assets, such as a camera or automobile.
If there’s any question that your activities could be considered a hobby, these tips will help you stay proactive for tax purposes.