Are you living your dream? Are you passionate about your business? Can you not wait to get back to your business everyday?
The IRS might think that you love your business so much that it is really a hobby.
What is the difference between a business and a hobby?
With a business, you are entitled to deduct all ordinary and necessary expenses. With a hobby, however, you can only deduct the expenses to the extent you have income.
The IRS uses 9 factors to determine whether a taxpayer is engaged in a business or a hobby.
- Was the activity conducted in a business-like manner?
The rationale behind this factor is that you will act differently if you are conducting a business rather than simply engaging in a hobby. For example, someone in the business of being in a band might schedule a number of performances, and have a plan on how to increase attendance. Someone in the hobby of being in a band might have performances on an ad hoc basis. Some elements that may be considered are: whether there is a business plan; if you maintain financial records; if there is a separate bank account; and whether you acted as a prudent business person.
- The taxpayer’s expertise or that of his/her advisers.
Whether you have sufficient expertise to demonstrate that you know how to make the activity profitable is another important factor.
- The time and effort expended in the activity.
The more time you dedicate to the activity, the more likely it is that the activity will be consider a business.
- Do you expect the activity’s assets to increase in value?
If the activity involves accumulating assets, such as coins, you must show that you expected the value of the assets to increase. That would indicate that you had the intention to sell them for a profit, which is an important factor to be considered a business.
- The taxpayer’s success in similar activities.
If you have been successful with related activities, it is more likely to be considered a business. On the other hand, if all of your similar activities have lost money then it is more likely to be considered a hobby.
- The taxpayer’s history of income or loss.
This is similar to the prior factor, except that it looks only at this one activity. If this activity consistently makes money, then it is likely to be considered a business. If it consistently loses money or only occasionally makes a profit, it is likely a hobby.
- The amount of occasional profits.
If you make a lot of money, then it is more likely to be considered a business. If the activity only makes a minimal amount of money, it is more likely to be considered a hobby.
- The taxpayer’s financial status.
If most of your income is derived from other sources, then this activity will look like a hobby. On the other hand, if most of your income comes from this activity it looks like a business.
- The personal pleasure the taxpayer derives from the activity.
This is a subjective factor. You can love what you do, but if it looks like that is a greater motivation for you than money it will likely be deemed a hobby.
Outside of these factors, there is a safe harbor available to taxpayers. If the activity has been profitable for 3 out of the last 5 tax years, including the current year, then the IRS will presume that the activity is carried on for profit (i.e., that it is a business). If you breed, show, train, or race horses, you only have to be profitable for 2 out of the past 7 years in order to qualify for this safe harbor.