When the IRS Classifies Your Business as a Hobby

Disclaimer: I’m never anyone to give tax advice, my default line is always, “this is what I’ve seen, but to get current and more updated information related to your taxes, you need to at least speak to an accountant or a C.P.A.”

When starting a business, this is something that you need to understand going into the idea of starting your own business. The first thing you need to ask yourself is, are you in business to make a profit. For most people, that answer is a yes. According to Kabbage.com, the I.R.S. considers your activity as not-for-profit for sport or recreation (that is, a hobby), and it says you cannot deduct expenses to get a loss to offset other income. Many legitimate businesses start with a loss in their first few years.

For most resellers or business owners starting, the tax implications are probably the most daunting. One more addition you need to add to your team is a good accountant or C.P.A.

If your business claims a net loss for too many years or fails to meet other requirements, the I.R.S. may classify it as a hobby, which would prevent you from claiming a loss related to the business. If the I.R.S. classifies your business as a hobby, you’ll have to prove that you had a valid profit motive if you want to claim those deductions.

The significance of the hobby’s income is subjective, but many find it’s time to make the switch from hobby to business when the hobby’s income rivals or beats your income from your day job. … But it’s a common rule of thumb that any hobby generating a large amount of money should register as a business, according to inc.com.

The Internal Revenue Service allows you to take a tax deduction for legitimate losses incurred in your business’s operation. However, if your company claims a net loss for too many years or fails to meet other requirements, the I.R.S. may classify it as a hobby, which would prevent you from claiming a loss related to the business. If the I.R.S. classifies your business as a hobby, you’ll have to prove that you had a valid profit motive if you want to claim those deductions.

Earning a profit

The I.R.S. expects that if you start a business, you intend to make money at it. If you don’t, your business might be a hobby. To determine if your business is a hobby, the I.R.S. looks at numerous factors, including the following:

  • Do you put in the necessary time and effort to turn a profit?
  • Have you profited from this activity in the past, or can you expect to make one in the future?
  • Do you have the necessary knowledge to succeed in this field?
  • Do you depend on income from this activity?
  • Are your losses beyond your control?

The practical standard for business classification

The I.R.S. safe harbor rule is that if you have turned a profit in at least three of five consecutive years, the I.R.S. will presume that you are engaged in it for profit. The gain must appear in 2 of the last seven years in the specific case of horse training, breeding, or racing. It can, presumably, because these endeavors involve a significant amount of risk.

Consequences of hobby classification

Generally, the I.R.S. classifies your business as a hobby; it won’t allow you to deduct any expenses or take any loss for it on your tax return.

If you have a hobby loss expense that you could otherwise claim as a personal expense, such as the home mortgage deduction, you can claim those expenses in full.

For tax years before 2018, other expenses, such as advertising, wages, insurance premiums, depreciation, or amortization, may also be usable as a miscellaneous itemized deduction subject to 2 percent of your adjusted gross income. However, you must have earned total income in your hobby than the amount of all of these deductions. In that scenario, the I.R.S. would categorize your hobby as a business anyway.

In 2018, miscellaneous itemized deductions were no longer deductible, and therefore, no hobby expense can reduce hobby income.

Preventing your business from being classified as a hobby

Running a hobby as a business could very possibly trigger an I.R.S. audit. If your business is legitimate, keeping accurate and extensive records could help prevent your business’s classification as a hobby.

In addition to demonstrating your professional approach to your business, records and receipts can help document your profit motive. A written business plan is often a prerequisite for indicating an intent for profit, and it can also show ways in which you are modifying your business to cope with losses.

Disclaimer: I’m never anyone to give tax advice, my default line is always, “this is what I’ve seen, but to get current and more updated information related to your taxes, you need to at least speak to an accountant or a C.P.A.”

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schodermedia

A public relations and E-commerce consultant in New Mexico. I am also a longtime collector and online dealer of quality items. DM for all inquires. #thecollector #baseballcards #sports #antiques #collectibles #reseller