Business or Hobby – Are You Sure?
Do You Have a Bona-Fide Business or Is It A Hobby?
Things have been a little tight, money wise, and you decided to start a business with hopes of making a few extra bucks. Do you know what the IRS rules are and how they decide if you have a real business or hobby? You need to know these rules and make sure that you follow them.
Do You Intend to Make a Profit and Pay Taxes if You Do?
This is what it all boils down to…TAXES. The IRS knows that almost every new business isn’t going to make a profit the first couple of years. They have a general rule of thumb whereby they expect a loss (within reason) to be reported on your tax return for the first two years.
If you are operating a legitimate business, you can deduct all expenses of that business, even if it creates a loss. If instead, you have a hobby, you used to be able to deduct the expenses on Schedule A, itemized deductions, up to the amount of income you received. When the Tax Cuts and Jobs Act (TCJA) went into effect in 2018, it eliminated all deductions for hobby expenses.
With that in mind, what do you think the first thing the IRS is going to look at if you are audited? Exactly!
They will make you prove to them that your intent is to make a profit, and also show that you are maintaining proper business records for all income and expenses.
Unfortunately, there are always some individuals who try to con the system by claiming losses on their tax returns, knowing full well their so-called business is only a hobby. A good example of this is someone who enjoys making pottery. They sell some of the pottery to friends and family and then deduct every expense they can find, to create a loss for the tax return.
Is Your Activity a Hobby or a Business?
The IRS states that if you are operating a bona fide business, your primary purpose will be to earn income and make a profit. In addition, you will be engaged in the business on a regular basis with continuity. They look at each business on a case-by-case basis, depending on the type of business & circumstances.
The following nine factors are used by the IRS to determine whether your activity is a hobby or a legitimate business venture.
- Do you maintain complete books and other records for your activity and do you operate it in a business-like manner?
- Do you work enough hours in the activity to demonstrate that you are trying to make a profit?
- Do you depend on that income generated from the activity for your living expenses?
- If you have a loss, was it due to circumstances beyond your control, or were you in the start-up phase of the business?
- In order to make a profit, do you make changes to operations if necessary?
- Do you have the necessary knowledge or experience to operate the business? If not, do you use others that do?
- If you operated a similar activity previously, did it make a profit?
- Does the activity generate a profit in some years, and how much?
- Do you expect to make a profit in the future from appreciation of your business assets?
Does a Corporation Ever Have a Hobby Loss?
A regular C Corporation is a separate business entity and pays taxes at the corporate level, so the hobby loss rules don’t apply to them. However, a sub chapter S Corporation is a flow through entity, and profit and losses are reported on the individual owner’s personal tax return, so the hobby loss rules do apply to them.
There is no check box or other place on your tax return to designate your activity a business or a hobby. The IRS makes that determination based on many factors such as profitability and the number of years in business.
What if May Business Keeps Showing Losses?
A general rule of thumb the IRS uses is that a business will make a profit in three of the last five years. There’s a way for you to postpone the IRS decision on whether you have a business or a hobby. You can make an election on your tax return by using Form 5213, thereby postponing their determination for an additional two years.
How Can I Improve My Position to Show I have a Legitimate Business?
The primary way is to intend to make a profit by following good, acceptable business practices like the following:
- Set up a business checking account and use it only for the business activity
- Always keep personal and business expenses separate
- Keep accurate books and other records
- Register your business name with your state, or create a corporate or partnership entity
- Follow the laws of the state such as collecting sales tax and file annual returns as required. These same state requirements apply to the federal level as well.
- Maintain regular business hours and/or a business website.
How Do I Deduct Expenses for a Business or Hobby?
If you have a small business operating as a sole proprietor, you list the business income and expenses on a Schedule C on your personal tax return. The net taxable income from the Schedule C would flow to the other income on page one.
If you operate as a C Corporation, all income and expenses are reported on the Form 1120 corporate tax return. Any taxes to be paid are paid at the corporate tax rates in effect. They do not flow through to the personal tax return.
If you operate as an LLC, partnership, or a Sub S Corporation, the income and expenses are reported on those business returns (Form 1065 and Form 1120-S). The net profit or loss and other items are reported on the appropriate Form K-1, and then reported on the personal tax return.
If you are reporting as a hobby, the income is reported on page 1, line 8, and is not subject to self-employment taxes. Effective with the 2018 tax returns, the TCJA eliminated the hobby expense deduction through 2025.