Confucius got it right: “Choose a job you love, and you will never have to work a day in your life.”
In this struggling economy, many people have turned their hobbies into businesses.
At the same time, the Internal Revenue Service has been cracking down on individuals who claim they are running a legitimate small business but are not making a profit.
Irwin Pomerantz, a CPA with K&A offers suggestions to lessen the chance the IRS will rule against a small business practitioner.
He offers these examples:
A social worker and avid gardener sells canned preserves at the local farmer’s market.
A business executive who previously dabbled in jewelry-making now markets her wares online.
An expert in restoring classic cars offers his services to people in his community.
These hypothetical examples are all great ways to earn a living – or supplement existing income – doing something you love. Sure, it may have started as a hobby. That’s how many businesses begin.
But for tax purposes the question becomes: How will the IRS see it?
Pomerantz says that according to the IRS’ “Hobby Loss Rule,” if the IRS determines the activity is a hobby and not a business then deductions for business expenses cannot be greater than the income from that activity for the year.
If your new venture is profitable, it’s a pretty clear it’s a business. Your deductions won’t exceed your income. Case closed.
But if the new enterprise consistently generates losses (deductions exceed income), the IRS may declare it a hobby.
There are two ways to avoid the hobby loss rules. The first is to show a profit in at least three of five consecutive years.
The second is to run the venture in such a way as to show that you intend to turn it in to a profit-maker, rather than operate it as a mere hobby. The IRS says that the hobby loss rules won't apply if the facts and circumstances show that you have a profit-making objective.
How can you prove that you have a profit-making objective? In general, you can do so by running the new venture in a business-like manner.
More specifically, IRS and the courts will look at the following factors:
How you run the activity
Your expertise in the area (and your advisors' expertise)
The time and effort you expend in the enterprise
Whether there's an expectation that the assets used in the activity will rise in value
Your success in carrying on other similar or dissimilar activities
Your history of income or loss in the activity
The amount of occasional profits (if any) that are earned
Your financial status
Whether the activity involves elements of personal pleasure or recreation
Here are some things you can do to prove that you’ve got a business:
- Create business cards
- Hire professional advisors (business manager, financial advisor, bookkeeper, etc.)
- Open a separate checking account
- Get a P.O. box so you have a separate business address
- Create a website
- Get a business license
- Name your business and register your “Doing Business As” (DBA) name
The bottom line: take yourself seriously. If you treat it like a business, the IRS will be more likely to see it your way.