You’ve heard the saying that a person must “walk the walk” to prove what they say is true. That holds true when you are telling the IRS that you are engaged in a business.
There is a big difference when the IRS classifies income as hobby income and not business income. Hobby expenses cannot exceed hobby income.
Therefore, any hobby loss cannot offset other income. Most new endeavors have losses their first few years that exceed the income from these ventures. In order to take advantage of these losses, the activity must be from a business.
The IRS says that if your activity shows a profit for any three or more years in a period of five consecutive tax years, you are presumed to be engaged in a business. This, however, does not mean the deductions stated on your return cannot be challenged by the IRS.
If you didn’t have a profit three out of five years, you must show that your objective is to make a profit. The courts have looked at the following factors in deciding if an endeavor is a business or a hobby.
• Is there a business plan and projections? The key is to project an overall business profit. Business plans provide directions to the business owner, investors, bankers and the IRS. If your goal is to make a profit at some point, outline when you reasonably expect this to occur.
• Are the activities conducted in a businesslike manner? This is probably the single most important factor that the IRS uses in judging a business’s intent. Open a separate bank account. Keep separate records. At the least have a yearly income statement and balance sheet.
• Are the activities conducted like a similar profitable business? Advertise your business. Have business cards and stationery. If you conduct your activity like other successful people in the same business, you have a strong argument that you’ve conducted your activities like a business with the expectation of making a profit.
• Prior business experience is important. If you have prior business experience with your product or service, this can make a big difference to the IRS. If you have no prior experience in the activity, your profit motive is more questionable.
• Devoting some time regularly to the activity. You do not need to conduct your business fulltime, but the more time and effort the better. Document your time.
The IRS doesn’t care if you make money as long as you’re trying to make a profit. Business losses can have a significant impact on the amount of taxes you owe. Legitimate losses from a business can offset other income, thus reducing your tax liability.
Using the above guidelines can strengthen your stance that the activities are for a business and not a hobby.
For more information regarding IRS notices, visit www.irs.gov and type “Hobby versus Business” in the search box.
Tracy Bunner is an enrolled agent and tax preparer with a practice in Harrisville. She can be reached at 801-627-2212 or tracystaxservice@yahoo.com.
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