Whether it’s the startup of your dreams, that side-gig to which you devote all your spare time, or your main moneymaker, if you’ve taken a big loss in your endeavor, while deducting your expenses as that of a business, there comes a time when the IRS will question whether you’re running a business or simply have a hobby.
Want to know how best to protect yourself in a potential audit and ensure you get your best tax deduction? Here are 9 factors the IRS use to differentiate a hobby from a business.
#1) The manner in which the taxpayer carries on the activity.
The first thing a tax court will look for is proof that you were conducting your endeavor like a business, which can often mean anything from keeping accurate bookkeeping and records, to maintaining business-like policies, and separating business and personal accounts.
#2) The expertise of the taxpayer or his advisers.
As a business owner should always be improving their craft, the IRS also looks to see if the taxpayer has spent any effort to continuously learn more about their trade – especially when relating to market research and how to make their endeavor more profitable.
#3) The time and effort expended by the taxpayer in carrying on the activity.
In the case of a hobby, it’s usually only pursued when convenient or fun to the taxpayer. Which is exactly why the amount of time and effort spent working throughout the week is a great tell whether the endeavor is a business or not.
#4) The expectation that the assets used in the activity may appreciate in value.
Put simply: is it possible for the taxpayer to make a continuous profit – given time – through the endeavor, or not? If not, it’s a hobby.
#5) The success of the taxpayer in carrying on similar or dissimilar activities.
Tax courts may also look at the taxpayers success with business endeavors in the past – namely whether or not they were able to make a profit, or if it failed eventually.
#6) The taxpayers history of income or losses with respect to the activity.
Past endeavors are fine, but what about the one in question? Has the taxpayer managed to make a profit within the time that’s to be expected? Is that profit predicted to increase slowly with more time?
#7) The amount of occasional profits.
Bottom line: as a business is defined as “an endeavor with the intention of earning a profit”, if the number of profitable years are slim or inconsistent, then it’s likely a hobby.
#8) The financial status of the taxpayer.
If the taxpayer is offsetting lost profits through another income source, as the endeavor is neither earning a strong profit or taking up a majority of the taxpayer’s time, tax courts may see it as a hobby.
#9) Does the activity lack elements of personal pleasure or recreation?
While no one ever said you can’t love your job, it’s still work, so if the endeavor is seen as “too fun”, a tax court may wonder if it’s a more of a recreational hobby.
Either way you look at it, a business is meant to earn you income, so it makes sense the IRS would suspect if you’re spending time and money on something that’s not earning you a return.
But as miscellaneous expense deductions – commonly used for hobby taxes – are no longer allowed under the TCJA, make sure you don’t miss out on important tax deductions by keeping in-depth records of your business endeavors, while proving the success you strive for!