Is Your Venture A Business Or A Hobby?

How to avoid the pitfalls of being labeled a "hobby" by the IRS

You may have a "side" business that is not your main source of income, but provides you a combination of pleasure and profit potential. So often many hobbies become very successful business ventures, but while these are becoming successful and thriving businesses, are you taking the necessary steps to legitimize the deductions on your tax return? Maybe your business has future profit potential, and that potential might be met sometime in the future. Sure it's generating losses now, but one day, it's going to make you rich.

If your "hobby" business continues to show a loss year after year while raising horses, playing music, cooking, performing aerobics or operating any side business, these will draw IRS scrutiny, especially with the IRS' new initiative to close the tax gap.

The IRS will disallow losses claimed if they deem the business to be a hobby versus a real business. Here are some basics you should consider:

The IRS will generally assume a business is not a hobby if it showed a taxable profit in three of the previous five tax years (two out of seven years for horse breeding and other horse-related activities). If you are questioned before this time frame has elapsed, you can file Form 5213 within 60 days of receiving an IRS notice to delay the determination until the end of the fourth tax year (sixth year for horses). Be aware, however that Form 5213 also extends the statute of limitations for that activity.

Just because the business isn't showing a profit does not preclude the loss from being deductible. It simply becomes a little more trickier to prove the profit motive.

The IRS has provided guidance on what factors it will use to determine whether a business with a taxable loss is actually a for-profit venture:

• Does the time and effort put into the activity indicate an intention to make a profit?

• Does the taxpayer depend on income from the activity?

• If there are losses, are they due to circumstances beyond the taxpayer’s control, or did they occur in the start-up phase of the business?

• Has the taxpayer changed methods of operation to improve profitability?

• Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?

• Has the taxpayer made a profit in similar activities in the past?

• Does the activity make a profit in some years?

• Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?

You might think that your hobby is a business and you might want to treat it as such. Just be careful that you take the steps necessary to treat it as a business. Here are some suggestions to help ensure that your hobby business will be considered a business for tax purposes:

• Open a checking account for the business separate from his personal account.

• Keep track of your income & expenses in a ledger.

• Take a class or attend a seminar on how to make his business profitable.

• Document an annual plan that includes goals for the year to make the business profitable.

• Set up a budget for the business and/or a projection showing profitability in future years

Remember, many of today's successful businesses had their beginning as a small, garage/home oriented business that started as a hobby while the entrepreneur went to school or worked full-time at another job. So, don't be discouraged if your business doesn't have the immediate success you have dreamed about. If it's a good idea stay with it and you will be successful.

Contact us to discuss how DAF Associates can help you get started in business.