So you had a great idea, decided to take a risk and embarked upon the adventure of starting a business. From your perspective, you’re a business. From your customer’s perspective, you’re a business. However, from the IRS’ perspective, that determination remains to be seen.
The IRS has a set of rules called the hobby loss rules that determine how expenses and losses are treated depending on your classification as a business or hobby. Let’s start by defining each of them.
What is a business?
Simply put, a business is something that trades value for value while trying to make a profit.
This exchange of value could be your time for money, a product sold for money or in some instances, your time for someone else’s time all with the intention of making a profit.
Essentially, you need to retain more value (money) than you give away in order to make a profit. Profit should always be one of your main goals, if not the main goal, of your business.
There are many reasons to run a business, and profit isn’t always the main objective. But, when we’re thinking about Uncle Sam, profit is a major part of being a business.
What is a hobby?
On the flip side, a hobby is something that trades value for value but not for a profit. Hobbies are usually just something we enjoy to do. Take traveling for example…
Traveling costs money. Exploring the world sounds like a dream, but at the end of the day, it costs a lot of money and makes nothing. This is a hobby.
Now, what if your travel blog begins to gain traction and starts making a few hundred dollars a month? Well, that’s awesome! But, how much money is it making? Would you still travel even if you weren’t making any money? Are you trying to make a profit? Do you run it like a business?
Why do I care?
Any income you earn has to be reported on your tax return, but the source of that income (business or hobby) is subject to different rules with Uncle Sam.
Businesses have the ability to deduct the majority of their expenses from income as long as they are ordinary and necessary in the course of the business.
Hobbies are subject to the hobby loss rules. Under these rules, your hobby expenses are no longer deductible from your hobby income. So, in essence, you have to pay tax on the hobby income without getting a break for the costs of your hobby.
Fortunately, hobbies are not responsible for paying self-employment taxes so that will help a little, but the hobby classification could hurt a lot if you have significant expenses and no ability to deduct them.
What can I do?
Here are some things you can do today to set your business up as a for-profit activity and hopefully not have to worry about the hobby loss rules.
1. Run Your Business like a Business!
Do you run your business like a business? Are you actively selling and trying to get customers? Do you keep accurate financial records? Do you have a separate bank account? Are you trying to make a profit?
The answers to all of these questions should be a resounding YES! This will make it very difficult for Uncle Sam to disregard your business.
2. Document Your Time & Efforts
Keep track of your time spent on the business. Time equals money, and money equals profit (at least someday). When you spend time and effort on your business, it’s hard for someone to disregard your business.
If you spend enough time on the business, you could also avoid treatment as a passive entity. There are many other rules related to passive entities and the treatment of passive losses so it would be good to document as much time as you can.
3. Start-Up Phase is Okay!
Losses are expected in the early years of your business (as long as they are part of the normal course of business). The IRS understands that, but long-term continuous losses are a definite red flag.
4. Make Attempts to Improve
Are you actively trying to make your business profitable? Are you implementing changes in your operations? Have you adapted your sales strategies or products? Have you sought out help?
If you are past the early years and still ending up with losses, the answers to these questions should all be YES! Making an attempt to turn the business around and make it profitable speaks volumes.
Uncle Sam has the final say over whether your business is considered a hobby or a business, and there’s really not a full-proof plan for you to guarantee your classification. (Of the IRS’ nine different guidelines on this matter, no one item matters more than the next. They are all taken together as a summative view of your business.)
Here is a checklist that you can use to help determine your classification.
Just remember, no matter what you may think, the IRS has the final say.
Note: This blog post is meant for educational and informational purposes only. Please contact a tax or accounting professional if you have specific questions about what this means for your business before taking any further action.