For federal tax purposes, the determination of “business” or “hobby” is a matter of deduction. If your new venture is considered a business, you can deduct losses against other income.
However, when the activity is classified as a hobby, the “hobby loss” rules limit the amount you can write off. Expenses you incur might be deductible only if you itemize – or they might even be nondeductible. Proper bookkeeping here is important for record keeping purposes.
The distinction affects the amount of tax you owe. So how can you prove you’re trying to run a money-making business despite several years of losses?
One test you’re probably familiar with is the general rule of earning a profit in three of the past five years. If your business has more income than deductions in three of five consecutive taxable years, the IRS generally accepts that you have a profit motive. (The time frame is two years in seven for certain horse-related activities.)
Unable to meet that test? Additional factors play a role as well. For instance, the Tax Court agreed that a volleyball consulting service with multiple loss years qualified as a business, in part because of a businesslike manner of operation. Among other items, the Court mentioned the maintenance of a separate bank account and accurate records as support for a profit motive.
Positive indicators of your profit-making intentions also include your expertise in the activity, the time and effort you put into your new business, and your success in other ventures.
If you’d like a complete list of the IRS “business vs. hobby” criteria, please contact us. We’ll be happy to review the guidelines with you.David Bradsher, CPA