Updated: Aug 17, 2020
"Preventing Your Business from Being Classified as a Hobby"
In the world of side-hustlers and small business, it is very important to understand the difference between an activity that is classified as a business vs. hobby for tax purposes. A lot of tax cases used to center around side-gigs with high pleasure-to-effort ratio such as motorcycle racing; however, the IRS has expanded its view to taxpayers who conduct an activity as their primary career, but just isn’t profitable.
A trade or business is an activity done with continuity and regularity with
the primary purpose to make a profit. A hobby is classified as an activity engaged in for recreation, sport or other purposes, not to make a profit.
Consequences of Hobby Classification:
The ramifications for being treated as a hobby are severe. With a business you can deduct expenses and generate a loss; however, when you’re conducting a hobby you are not able to deduct any expenses or generate losses. YIKES!
Nine (9) Factors used by IRS:
To determine if your business is a hobby, the IRS looks to nine (9) factors: (No one factor is determinative).
1) The manner in which the taxpayer carries on the activity. “Do you treat it like a business and keep accurate books and records”;
(2) The expertise of the taxpayer or the taxpayer’s advisors; “Did you do your research and/or consult with industry experts?
(3) The time and effort spent by the taxpayer in carrying on the activity; “Did you have another job/profession?
(4) The expectation that assets used in the activity may appreciate in value;
(5) The taxpayer’s success in carrying on other similar or dissimilar activities;
(6) The taxpayer's history of income or losses from the activity;
(7) The amount of occasional earned profits, if any;
(8) The taxpayer’s financial status “Do you depend on the income to support yourself”; and
(9) The presence of elements of personal pleasure or recreation.
The general rule is that if you have not turned a profit in at least three of the prior five years, the IRS will categorize your business as a hobby.
There have been several cases decided on the hobby vs. business classification and a common trend has emerged: if you don't take your business seriously, then the IRS and the courts won't either. Therefore, it is absolutely imperative that you conduct your activity in a businesslike manner. Some action steps that you can do to treat your business like a “real business”:
1. Have a business plan
2. Maintain a separate bank account
3. Keep separate, accurate, books and records (just having a Quickbooks account doesn’t count!)
4. Pay close attention to the health (review books) of the business and cut costs if losses are continuing to rise
5. Set clear goals
6. Consult with industry experts for advice on how to become successful in the business
Lastly, if you are diligently working on growing the business and can really show that you are trying to generate profits, you will have a strong argument against a hobby classification if the issue comes up in an Audit.
§ 1.183-2: Activity not engaged in for profit defined.
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