How's that old saying go? "Nothing is certain except death and taxes." But... what if you're not certain about what those taxes are on? More and more, people are engaging in hobby activities that turn into a source of income. It can be confusing to determine whether or not that hobby has become a taxable business that generates expenses. To avoid hefty bills or legal issues, the IRS needs to know exactly what kind of operation you're running. Read on to determine if your hobby is a business or if your business is a hobby.
1) Have You Made a Profit?
Whether or not you've made any money is one of the first (but not only!) things the government looks at when deciding if an operation is a business. According to the IRS Safe Harbor rule, if your company or brand has made a profit in three of the past five years, it is a business. Once you begin to consistently generate income, the IRS decides that your goal is to turn a profit. (For some tips on figuring out profit versus revenue, check out last week's blog post on defining a small business.) However, if you are not generating any income, the government may decide that your business is just a hobby.
2) Did You Put in the Time and Effort to Make a Profit?
Even if your business has yet to turn a profit, the IRS considers other factors typical of the start-up process. Most small companies do not see profits until year 3 or 4. For many starting out, income alone will likely not reflect the amount of time and energy that's been invested. If it's clear to the IRS that your intention is to earn money from your work in order to support yourself, a small business in the red is still a business. So, how do you communicate that to the government? Maintaining a clear "paper trail" shows the IRS that you mean business--yes, pun intended! Log business expenses, save and organize receipts, track your hours, send formal invoices (when applicable), and keep a close eye on your revenue and income. Maintaining a separate bank account and credit card(s) for your business also demonstrates your intentions. So long as you can definitively prove that you've made a good-faith effort to turn a profit, the IRS will honor your intentions. If none of this applies--or even appeals--to you, then your hobby has not quite reached small business status.
3) The IRS Needs to Know Either Way
Running a hobby as a business--whether or not you're turning a profit--could potentially be grounds for an IRS audit. Legitimate small business owners can claim losses and write off business expenses. On the other hand, money spent supporting hobbies cannot be written off to the IRS as a business expense. Essentially, the government doesn't want you to declare losses for a hobby that never had intentions of being a business. For example, think of professional versus hobby photography. Here's an example:
Person A decided to open a photography business. That means they need to spend money on buying a new camera. They decided to open a home-office, so their business helps pay for their internet expenses. Person A starts selling packages, and they need to start buying prints for their clients. Person A ends the year with $5,000 in revenue, but they spent $6,000 on all of their start up costs. Person A can prove to the IRS that they were operating in good faith as a business (sending invoices, keeping receipts, opening a separate business account), so they are allowed to claim a $1,000 LOSS on their income taxes ($5,000 revenue minus $6,000 in expenses).
Person B decides they want to learn photography for fun. They spend money on a buying a new camera. They also keep their photography gear at their house, and use their own internet to look up tips and tricks. Person B decides to order prints of their photography for their friends and family. However, Person B never set up a website. They never opened a business checking account. They never advertised or made a measurable effort to sell their services. At the end of the year, they also spent $6,000 on all of their photography, but sent $0 in invoices. Person B is NOT allowed to write off a $6,000 loss on their taxes. To the IRS, this was just a hobby. The expenses accrued for this hobby do not go to lower Person B's tax burden.
As you can see, an accurate classification of "hobby" or "business" is crucial!
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