Taxation 101: Hobby or Business?
© 2014 Elena Fawkner
For many of us it's tax time again. For others, tax time is
just around the corner. So, how was business this year? Did
you make a profit? If your business is very new, most likely
you made a loss. Oh well, at least you can write it off, right?
Well ... maybe. Whether you can write off your business losses
depends on whether your business really is a business or a
hobby. "Well, of course it's a business!", I hear you say. "I
don't put myself through this for the fun of it!".
In this article we look, first of all, at the things you need to be
doing in your business to make it very clear to the IRS that
you are, indeed, running a business and not merely indulging
in a hobby. The reason this is so important is that although you
have to declare and therefore pay tax on the income you make
from a hobby, you can't write off your losses and may not even
be able to deduct your expenses at all. Secondly, we'll take
a look at some of the common business tax deductions you
should be thinking about in the context of your business. Even
if you didn't have your act together last year in terms of keeping
records and receipts for all this stuff, at least you can get your
house in order for when this year's tax return is due.
HOBBY vs. BUSINESS
The crucial distinction between a hobby and a business is
whether you engage in the activity with a profit motive. Now,
by profit motive, we don't mean that "gee, it's really great
that I can make money doing something I love", we mean "I'm
doing this with the intention of making a profit and if I can't make
a profit doing this then I'll find something else to do that will make
me a profit". The difference is one of motive. In the former, the
motive for the activity was the doing - the enjoyment inherent
in the activity itself. Making money was an incidental, albeit
most welcome, benefit. In the latter, the motive for the activity
was to make a profit. That's not to say that you can't enjoy
what you choose to do to make that profit, it's just that your
primary objective must be to make a profit such that if this
venture is inherently unprofitable, you would presumably choose
not to pursue it. With a hobby, on the other hand, even if the
activity was inherently unprofitable, it is something you would
choose to do anyway.
OK, so much for your own subjective intentions. How does the
IRS decide whether you truly have a profit motive? There are
two ways it goes about it. The first is an objective test. Quite
simply, the IRS will look at your tax returns for the last 5 years
and if you made a profit during at least 3 of those years, you
will satisfy the profit-motive test. If you don't meet this test or
if your business is new and you haven't filed 5 tax returns, then
the IRS will apply a subjective standard. In applying the
subjective standard, the IRS auditor considers and weighs
several factors, including:
=> Businesslike Manner of Carrying On Activity
The IRS will look at how you carry on your activity. Do you keep
a good set of books and records or do you chuck receipts into
a battered shoebox? Do you have separate bank accounts for
your business? Do you invest in advertising, marketing and
=> Time and Effort Invested
Is your business a sideline or something you pursue more or
less full-time? Obviously if you devote substantially all of your
available time to the activity, the more likely it is that you have
a profit motive since that is your primary source of income.
Things can be trickier if you work full-time and your business
is something you pursue on the side. Just be sure you can
demonstrate an ability to devote substantial time and effort
to your business. Unlike a hobby, a real business in which
you have a profit motive demands time and effort. It's NOT
something you just don't get around to this week because
"things came up". With a hobby you can do that. With a
business you can't.
=> Track Record of Profit-Making Ventures
If you have a history of involvement in profit-making activities
in the past, this will be relevant to your ability to make a
profit in your current venture. Conversely, if you have no
track record at all of involvement in profit-motivated
pursuits, the IRS is going to be looking for evidence that
you know what you're about and have sufficient experience
and expertise to turn your activity into a profitable
=> Nature of Losses
The nature of the losses you claim will also be a relevant
consideration. If you're a start-up, substantial first year
losses are to be expected. After that, however, you should
be demonstrating a shift towards profitability. Your second
year may still show a loss but it should be a smaller one
that your first and your third should be smaller again than
that, and so on.
=> Changes in Operations
If you continue doing things the same way, day in day out
even when they're clearly not working to make you a profit,
that's a strong indication that you're engaging in a hobby
and that you don't have a profit motive. On the other hand,
if you can demonstrate changes in operations to attempt
to fix what isn't working for you, this will lean towards a
=> Profit Patterns
The IRS will also be looking for profits in some years, even
if losses occur in others. A pattern of small profits and large
losses every year, year in, year out will raise suspicion.
This is just a sampling of the types of factors the IRS will
give weight to in adjudging whether your "business" is truly
a business or a hobby. For more information, visit the IRS
website at http://www.irs.gov.
OK, now that we all have healthy profit motives and are
therefore running serious businesses here, let's finish up with
a quick look at some of the common business deductions
for home-based businesses:
=> Home office deduction. For a complete article on this
deduction, read "Taxing Times ... The Home Office Deduction" at
=> First year expense deduction. You can deduct up to $20,000
worth of equipment as a current expense during your first year of
business with this deduction. Otherwise, you would have to
deduct it over a period of years depending on the depreciation
schedules for the assets concerned.
=> Auto expenses. If you use your car for business purposes,
you can claim mileage or depreciation. The mileage method allows
you to deduct the amount per mile the IRS allows for the particular
year. The depreciation method allows you to take a depreciation
deduction on the cost of your car and add to that all costs and
expenses associated with running your car including maintenance.
=> Health insurance payments (proportion).
=> Business insurance premiums.
=> Contributions to retirement plans.
=> Continuing education expenses related to your business.
=> Gifts valued at up to $25 per person per year.
=> Internet and email services - ISP, webhosting etc..
=> Interest on business credit.
=> Entertainment - 50% of ordinary and necessary business
expenses for entertaining clients, employees, etc..
=> Advertising, marketing and promotion expenses.
=> Membership dues for professional associations.
=> Subscription costs for professional and trade publications.
=> Local travel expenses e.g. taxis, trains etc..
=> Business travel expenses - airfare, accommodation, meals,
=> Furniture and equipment.
=> Business cards, stationery and office supplies.
=> Parking fees.
=> Bank fees on business accounts.
For more detailed treatment of each of these deductions, as
well as many others, visit the IRS website at http://www.irs.gov.
Tax time is no fun for any of us but there is no reason to
make it any harder than it has to be. If you keep putting off
getting your tax return prepared because you just can't face the
thought of going through that shoebox at the back of your
closet to organize your receipts, make a vow that this is the
last year you will do this to yourself. It's still early enough in
the year to get your act together and by this time next year
you could be focusing on your business rather than stressing
out about something as unnecessary as tax-time hassles.
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Elena Fawkner is editor of Home-Based Business Online.
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Monday, 16-Jan-2017 11:09:59 CST