Don't Get Caught By The Hobby Trap
by Janet Attard
Are you running a business or making money from a hobby? If the IRS believes your income producing activity is a hobby, you won't be able to deduct all of your business expenses. Here's what you need to know about the hobby loss rule and how to keep protect your business expense deductions if your type of business could be considered a hobby by the IRS.
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If you produce income from a business activity the IRS could consider a hobby (writing, photography, painting, woodcrafts, for example), and if you are losing money at it watch out! If you are not meticulous about keeping records of everything you do, you could lose the right to deduct some of your expenses.
The reason: the IRS has different rules for the deduction of businesses expenses and hobby expenses. If the IRS decides that your business is an income-producing hobby, the expenses you incurred will not be fully deductible. Here's how it works:
Most direct business expenses are fully deductible on Schedule C for sole proprietors. Additionally, if the direct costs of doing business exceeds your income from the business, you can use the resulting loss to offset (reduce) other income reported on Form 1040.
Hobby expenses are not considered business expenses, however, even if you make some income from your hobby. Hobby expenses can't be reported on a Schedule C. Instead, they must be reported as a miscellaneous expense on Schedule 1040 Schedule A of your personal tax return. They are subject to the same 2 percent floor as other miscellaneous expenses on Schedule 1040 Schedule A (they can only be deducted to the extent they exceed 2 percent of adjusted gross income). Furthermore, they cannot exceed your income from the hobby.
The Deciding Factor
So, how does the IRS decide whether something is a business or a hobby? The key is whether you can show the IRS that you have a profit motive for engaging in the income-producing activity. If your business revolves around something other people do as a hobby, and you lose money year after year, you could have your business deductions disallowed.
Avoid the trap
The IRS generally will presume your activity is a business if you show a profit in 3 of the last 5 years including the current year. (Businesses involved with race horses have to show a profit in 2 of 7 years).
If your activity fails this 3-of-5 year test, you may still be allowed to declare your expenses as business deductions if you can prove a profit motive. Here are some of the key factors the IRS will look at:
- Do you carry out the activity in a business-like manner
- How much time and effort do you devote to the activity
- Do you have expertise in the activity
- Are the losses due to circumstances beyond your control
- Have you tried to increase the profitability of the activity by changing your methods of operation
- Do you depend on income from the activity for your livelihood
- Have you made a profit on similar activities in the past
- Does the activity involve considerable work that could not be considered "pleasurable" (cleaning animal stalls, for instance)
When a business deduction is challenged on the basis of profitability, decisions are made on a case by case basis. But the more you ways you can prove your profit motive, the better.
Suppose you are in business selling hand-painted decorative items, and the business fails the profitability test. The IRS might consider it a business if you:
- have little or no other income
- regularly work at the business
- regularly have your items on sale at craft shows, craft malls, consignment shops or through other means
- keep accurate and complete records of your costs, inventory and sales
- have a separate bank account for your business activities
- have made changes in your businesss to try to counteract the losses.
On the other hand, if you only work sporadically at the business, if you decorate your own home with your handiwork or give them as gifts, and if you don't keep good records, don't regularly offer your products for sale to the general public, never analyze income and expenditures or make and carry out plans to increase profitability, the IRS is likely to declare that your "business" is a hobby. See the IRS website for additional information about the hobby rule.
About the author:
Janet Attard is the founder of the award-winning Business Know-How small business web site and information resource. Janet is also the author of The Home Office And Small Business Answer Book and of Business Know-How: An Operational Guide For Home-Based and Micro-Sized Businesses with Limited Budgets. Follow Janet on Twitter at http://www.twitter.com/JanetAttard.