If you produce income from a business activity the IRS could consider a hobby (writing, 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 hobby expenses and businesses expenses.
Most direct business expenses are fully deductible on Schedule C. 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. 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.
If you consistently lose money in your business, the IRS could claim it is a hobby and require you to report the expenses as hobby expenses, thereby limiting their deductibility.
Avoid the trap
What criteria does the IRS use to distinguish businesses from hobbies?
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:
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Do you carry out the activity in a business-like manner
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How much time and effort do you devote to the activity
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Do you have expertise in the activity
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Are the losses due to circumstances beyond your control
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Have you tried to increase the profitability of the activity by changing your methods of operation
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Do you depend on income from the activity for your livelihood
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Have you made a profit on similar activities in the past
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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.
If, for instance, you claim to be in business selling hand-painted decorative items, and the business fails the profitability test, the IRS would probably 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, and make changes in operations on the basis of an analysis of financial data.
But if you don't work regularly at the business, don't keep good records, don't regularly offer your products for sale to the general public, use many of your products to decorate your own home or to give as gifts, and never analyze income and expenditures or make and carry out plans to increase income the IRS is likely to declare that your "business" is a hobby.
Copyright 1990 and 1999, Janet Attard