Start a business in something you love? You are making little money but that does not matter – you are enjoying the tax deduction advantages. You can turn a seemingly expensive activity to a mini-business with a bunch of tax write-offs. What a deal! But then the shock comes when the IRS says, “No!” you have a hobby and your tax deductions are taken away.
Closely watched activities
The IRS takes a hard stance on activities that were started a a business but is deemed a hobby. Some of the closely watched activities are:
– Making arts and craft
– Collections things such as stamps and/or coins
– Writing
– Photography
– Breeding, training, showing, or racing animals (Horses, dogs, etc)
All about the expenses
There is a major difference between business activities and hobby activities. A business activity can write-off all business expenses – including expenses that create a business loss. A hobby activity can write-off expenses to the extent of hobby income.
Business Example: You in business of breeding horses. You made $20,000 in income. You have incurred $30,000 in expenses. As a business activity, you can write-off all expenses – resulting in $10,000 loss. (20,000 – 30,000 = -10,000)
Hobby Example: Your hobby is breeding horses. You made $20,000 in income. You have incurred $30,000 in expenses. As a hobby activity, your write-offs are limited to income earned – resulting in $0 income or loss. (20,000 income – 20,000 allowed expense = 0)
As you can see from these two examples, a business can write-off all expenses while the expenses of a hobby are limited to income earned. This is a significant difference if the activity generates a loss year after year.
5 year and 7 year rule
The main rule determining whether an activity is a business or hobby is the 3 out 5 year rule. Any activity earning a profit in 3 out of 5 years is a business. (Breeding, training, showing, or racing animals is 2 out of 7 years)
If the activity does not meet this requirement then the activity may be deemed a hobby.
Business Example
Year 1 – Profit
Year 2 – Loss
Year 3 – Profit
Year 4 – Profit
Year 5 – Loss
This is a business. The activity earned a profit in 3 out of 5 years.
Hobby Example
Year 1 – Loss
Year 2 – Loss
Year 3 – Profit
Year 4 – Profit
Year 5 – Loss
This is may be a business or hobby. The activity did not earn a profit in three out of five year.
9 Factors
If your activity does not meet 3 out of 5 year rule – or 2 out of 7 year rule – then you must consider other aspects of your business. The IRS reviews 9 factors in determining whether an activity is a business or hobby. 1. Whether you carry on the activity in a businesslike manner.
- Whether the time and effort you put into the activity indicate you intend to make it profitable.
- Whether you depend on income from the activity for your livelihood.
- Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
- Whether you change your methods of operation in an attempt to improve profitability.
- Whether you or your advisors have the knowledge needed to carry on the activity as a successful business.
- Whether you were successful in making a profit in similar activities in the past.
- Whether the activity makes a profit in some years and how much profit it makes.
- Whether you can expect to make a future profit from the appreciation of the assets used in the activity.
If your business is incurring a loss year after year, review the 9 factors. You can make changes to your business now to make sure your business stays a business and does not turn into a hobby. Click here for more information on the business versus hobby rules.