Business or Hobby Determination for IRS Taxes

You love planning parties.  Over the last few years, friends and family asked for your assistance on planning various celebrations: open house, graduation party, baby shower, wedding reception, and birthdays.  After awhile you started to think, could I start a party planning business?  Why not?  You may or may not earn money doing this.  It does not matter to you.  You have a normal full time job.  The party planning will be a side business for fun.

Enjoy Business Write-Offs

You start to learn from others that you could potentially write-off everyday expenses.  Write-off your car by placing a party planning company logo on it.  Go to dinner with a friend.  Talk about your new business briefly so you can write-off the dinner.  Plan a trip to Florida to visit your extended family.  They are going to love to hear about your new party planning business.  Since you talked business, you are going write-off your trip.

Now it’s tax time.  You gather all your tax documents.  The party planning business shows a significant loss.  This is great!  You reduced your normal job wages with business losses.  As a result, you are going to get a large refund.  This party planning business is perfect.

Until you Get Audited

All is good until you get audited by the IRS.  You learn that some of your expenses were not deductible.  You are unable to write-off your car just because you put a logo on it.  You are unable write-off meals with friends and family just because you happened to mention your party planning business.  You can’t write-off vacations just because you met with a family member for an hour to talk about your party planning business.  The IRS limits all business expenses to write-offs that can be attributed to the party planning business.  Then the IRS throws another ringer at you.  The IRS decides to treat your business as a hobby.

The main rule for business versus hobby is the three out of five year rule.  The party planning activity may be considered a hobby if the activity didn’t make a profit in three out of five consecutive years.  (The rule is two out of seven years for training, showing, breeding, or racing horses.)  If your party planning activity is ruled a hobby, then your expenses may be limited even further.   There are other factors to consider if your business has lost money every year.

Before you start a business, I highly recommend discussing the tax implications with a tax professional.  You want to make sure the business starts on the right foot.  Click here to read more about the hobby rules.