Business or Hobby: Why Does the IRS Care?

You fix up cars in your garage for your friends. You collect stamps and go to shows occasionally to buy or sell. You paint in your spare time, and donate a few paintings every year to a charity auction. You buy and sell collectibles at auction, or you actively buy and sell on eBay. What are the possible tax consequences from these activities? Now is the time to review the IRS tax rules to make sure you know how track this income and expenses so you'll be ready at tax time.

If you make money from these activities, the IRS tax rules state that 100% of this income is taxable on your personal 1040 income tax form. Whether you need to file a return or not is a separate matter, but there is no dispute that this is taxable income. If you consider this activity to be a "business," you can deduct your reasonable and necessary expenses and only be taxed on your profit. But if this is truly a hobby for you, then your expenses cannot be deducted. This can be a tricky issue when this activity loses money.

In almost every circumstance, your best course of action is to treat your hobby as though it is a business. That way, you can deduct your expenses if you want to, especially if you are faced with a potential loss at the end of the year. Conversely, if you do not conduct your business in a business-like manner, you run the risk of having the IRS determine that you are actually participating in a hobby. If that happens, you cannot deduct your expenses or any losses.

The IRS tax rules make a distinction between a "hobby" and a "business." The basic premise is that an activity is a "business" if you are actively trying to make money from it. It is a "hobby" if you participate in the activity primarily for the enjoyment or satisfaction you derive from the activity, not because of any income gained. Though no single factor is determinative, the IRS has established several questions it considers when faced with a question whether or not losses can be deducted, including:

-- Is the activity carried on in a business-like manner (are expenses and income tracked, is the activity conducted regularly, etc.)?

-- Would the amount of time and effort you expend on the activity tend to indicate an intention to make a profit?

-- Has the income derived from the activity been applied to the support or maintenance of yourself or your family?

-- Do you have the skill and knowledge to make a profit in this area of endeavor?

-- Were any of the losses incurred due to circumstances beyond your control?

-- Have you ever made a profit with the same or similar activity in prior years?

If you can convince the IRS that these activities are not a hobby but in fact you are running a business, you are allowed to deduct all of the ordinary and necessary costs associated with these activities.

The IRS tax rules deem an ongoing activity to be a "business" if there has been a profit in any amount in three of the past five years. Unfortunately, even if a business meets this profit rule, the IRS always retains for itself the right to disallow any deductions in years when losses occur.

If an activity has made a profit in at least 3 of the last 5 years, the chances of it being considered an activity for profit, i.e., a "business," are very high. (There's an exception for businesses consisting of breeding, training, showing, or racing horses, which only have to show a profit in two out of seven years to be accepted as a business, but we will not deal with those situations here.) The activity needs to be substantially the same during those previous five years. If the taxpayer dies before the end of the 5-year period, the test period ends on the date of the taxpayer's death. If the business passes the profitability test, there are no limitations on the business expenses or losses you can deduct from your taxes.

But what if your business does not turn a profit in three years; how can you deduct your losses then? Losses may still be deductible on your tax return, even in your first year of business, if you can demonstrate to the IRS that this activity really is a "business" according to the factors listed above. The best way to prove this is by showing that you take the activity seriously and treat it professionally. Things IRS auditors look at include: business cards, an organized set of accounting records, tracking of income and expenses, separate bank accounts for the activity, maintaining current licenses and permits, using a separate part of your dwelling solely for the business, and engaging in marketing and advertising. All of these efforts will demonstrate that this really is a business, and a business loss can be deducted.

Another scenario that often occurs is that you file your tax return and you get a notice from the IRS that they are disallowing your business deductions. If you haven't been in business long enough to have a clear record of profitability under the IRS tax rules, and you aren't completely confident that you have been treating your business like a business, you have 60 days from the date of the notice to file IRS Form 5213. By filing Form 5213, you put the IRS on notice that you are requesting a postponement in any determination that your business is intended to make a profit until five years have passed after you began your business. The benefit of filing this form is that the IRS cannot question your business losses or restrict your deductions until after you have completed your fifth year. However, if you do not make a profit in three of those five years, the IRS can retroactively limit your losses and deductions, forcing you to refile and refigure your taxes. Form 5213 must be filed within three years of the due date (April 15^th) of your tax return for your first year in business.

Dealing with a tax dispute is never fun. Proactively knowing the IRS tax rules and treating all of your income-producing activities as a business can save you lots of headaches in the long run.

Source: Internal Revenue Service regulations