Business vs. Hobby

I’m posting this topic first for two reasons.  One, it is very important in terms of taxes to a small business.  I’ll talk about the tax implications in a later post.  Let me just say that it’s really not good to have your business reclassified as a hobby.  Secondly, is the IRS’s “facts and circumstances” for determination reinforces the importance of setting up your business properly.

Make a profit (income – expenses = profit) three or more years out of five, and the IRS says (most often) — you’re a business!  It’s those pesky losses that are a problem.  Even in good times, it takes several years for a business to be in the black.  Real businesses have losses.  This is where the “facts and circumstances” come into play.

Usually in “facts and circumstances” the IRS has some mighty slippery stuff, but in this area at least some of it makes a lot of good common sense.  These are the things that the IRS looks to when deciding if you are a business.

  • The manner in which you carry on your business (This is a biggie.  Keep business-like records.  Have a separate checking account and credit card.  Obtain proper license, registration, etc.)
  • Your expertise or the advisers you use (research strategies and trends in similar businesses, seek expert advice, and keep a record of what you do)
  • Time and effort your spend in the business (use some sort of log for time spend working in the business, even if it’s just notes on a calendar)
  • Do you expect your assets to appreciate in value
  • Have you done this before with success
  • Your profit and loss history with the business (Develop a business plan and periodically re-evaluate where you are and what you can do better)
  • Amount of occasional profits
  • Your overall financial status (Yes, if you have other resources, then they are more likely to consider what you do as a hobby)
  • Is the activity pleasurable (It’s a shame they don’t think your work could be fun!)

SUMMARY:  If you’re a business — act like one!

Comments

  1. So question, Connie…I used to know this, but I’ve forgotten. Is there a threshold for how much you can sell through your “hobby” before you have to report the income?

  2. That’s a good questions, Janet. The IRS says gross income includes all income from whatever source unless there is a specific exclusion. There is no exclusion for hobby income. So, technically all hobby gross income should be reported on page 1 of the 1040 and deductions (up to the amount of income) are reported on schedule A as miscellaneous deductions subject to the 2% rule. Do people report this? I would say probably not. However, the IRS is trying to close the “tax gap” and they may start looking harder at hobby income.

  3. This saddens me…In this economy, to be a full-time artist must be an anomaly. If one has other resources (such as savings, or perhaps a hubby who shoulders the bills), and one cannot make a profit at 3 years, are “we done?” My accountant only insinuates; will put him to the dartboard test at our next meeting…All I can say is I AM NOT DONE, no matter what the IRS says. I abide by the law, but I WILL NOT QUIT. I just don’t know what to expect if THEY reclassify me against my will. What do I need to do? Video my every day life to prove what I do???? I should think the Pres would be interested to see how many artists as small businesses are put out of work….this is not right….

    • Rhonda, some businesses are in the red for their entire existence and are still businesses. The IRS looks at all facts and circumstances, not just the other resources. It’s that if you have a profit 3 out of 5 years, then they don’t question it except under special circumstances. But it is tragic that so much of the tax code hurts the small business person when they are the backbone of our country.

  4. I am going to write to President Obama and Michelle….in this economy, every loss of a FT artist is a travesty….We Are Small Business….we need tax breaks. Period.

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