Business or Hobby?
by Elena Fawkner
For many of us it's tax time again. For others, tax time is just around the corner. So, how was business this year? Did you make a profit? If your business is very new, most likely you made a loss. Oh well, at least you can write it off, right? Well ... maybe. Whether you can write off your business losses depends on whether your business really is a business or a hobby. "Well, of course it's a business!", I hear you say. "I don't put myself through this for the fun of it!".
In this article we look, first of all, at the things you need to be doing in your business to make it very clear to the IRS that you are, indeed, running a business and not merely indulging in a hobby. The reason this is so important is that although you have to declare and therefore pay tax on the income you make from a hobby, you can't write off your losses and may not even be able to deduct your expenses at all. Secondly, we'll take a look at some of the common business tax deductions you should be thinking about in the context of your business. Even if you didn't have your act together last year in terms of keeping records and receipts for all this stuff, at least you can get your house in order for when this year's tax return is due.
HOBBY vs. BUSINESS
The crucial distinction between a hobby and a business is whether you engage in the activity with a profit motive. Now, by profit motive, we don't mean that "gee, it's really great that I can make money doing something I love", we mean "I'm doing this with the intention of making a profit and if I can't make a profit doing this then I'll find something else to do that will make me a profit". The difference is one of motive. In the former, the motive for the activity was the doing - the enjoyment inherent in the activity itself. Making money was an incidental, albeit most welcome, benefit. In the latter, the motive for the activity was to make a profit. That's not to say that you can't enjoy what you choose to do to make that profit, it's just that your primary objective must be to make a profit such that if this venture is inherently unprofitable, you would presumably choose not to pursue it. With a hobby, on the other hand, even if the activity was inherently unprofitable, it is something you would choose to do anyway.
OK, so much for your own subjective intentions. How does the IRS decide whether you truly have a profit motive? There are two ways it goes about it. The first is an objective test. Quite simply, the IRS will look at your tax returns for the last 5 years and if you made a profit during at least 3 of those years, you will satisfy the profit-motive test. If you don't meet this test or if your business is new and you haven't filed 5 tax returns, then the IRS will apply a subjective standard. In applying the subjective standard, the IRS auditor considers and weighs several factors, including:
Businesslike Manner of Carrying On Activity
The IRS will look at how you carry on your activity. Do you keep a good set of books and records or do you chuck receipts into a battered shoe box? Do you have separate bank accounts for your business? Do you invest in advertising, marketing and promotion?
Time and Effort Invested
Is your business a sideline or something you pursue more or less full-time? Obviously if you devote substantially all of your available time to the activity, the more likely it is that you have a profit motive since that is your primary source of income. Things can be trickier if you work full-time and your business is something you pursue on the side. Just be sure you can demonstrate an ability to devote substantial time and effort to your business. Unlike a hobby, a real business in which you have a profit motive demands time and effort. It's NOT something you just don't get around to this week because "things came up". With a hobby you can do that. With a business you can't.
Track Record of Profit-Making Ventures
If you have a history of involvement in profit-making activities in the past, this will be relevant to your ability to make a profit in your current venture. Conversely, if you have no track record at all of involvement in profit-motivated pursuits, the IRS is going to be looking for evidence that you know what you're about and have sufficient experience and expertise to turn your activity into a profitable sideline.
Nature of Losse
The nature of the losses you claim will also be a relevant consideration. If you're a start-up, substantial first year losses are to be expected. After that, however, you should be demonstrating a shift towards profitability. Your second year may still show a loss but it should be a smaller one that your first and your third should be smaller again than that, and so on.
Changes in Operations
If you continue doing things the same way, day in day out even when they're clearly not working to make you a profit, that's a strong indication that you're engaging in a hobby and that you don't have a profit motive. On the other hand, if you can demonstrate changes in operations to attempt to fix what isn't working for you, this will lean towards a profit motive.
The IRS will also be looking for profits in some years, even if losses occur in others. A pattern of small profits and large losses every year, year in, year out will raise suspicion.
This is just a sampling of the types of factors the IRS will give weight to in adjudging whether your "business" is truly a business or a hobby. For more information, visit the IRS website at http://www.irs.gov.
OK, now that we all have healthy profit motives and are therefore running serious businesses here, let's finish up with a quick look at some of the common business deductions for home-based businesses:
Home office deduction - For a complete article on this deduction, read "Taxing Times ... The Home Office Deduction" at http://www.ahbbo/homeofficetax.html.
First year expense deduction - You can deduct up to $20,000 worth of equipment as a current expense during your first year of business with this deduction. Otherwise, you would have to deduct it over a period of years depending on the depreciation schedules for the assets concerned.
Auto expenses - If you use your car for business purposes, you can claim mileage or depreciation. The mileage method allows you to deduct the amount per mile the IRS allows for the particular year. The depreciation method allows you to take a depreciation deduction on the cost of your car and add to that all costs and expenses associated with running your car including maintenance.
• Health insurance payments (proportion).
• Business insurance premiums.
• Contributions to retirement plans.
• Continuing education expenses related to your business.
• Gifts valued at up to $25 per person per year.
• Internet and email services - ISP, web hosting etc..
• Interest on business credit.
• Entertainment - 50% of ordinary and necessary business expenses for entertaining clients, employees, etc..
• Advertising, marketing and promotion expenses.
• Membership dues for professional associations.
• Subscription costs for professional and trade publications.
• Local travel expenses e.g. taxis, trains etc..
• Business travel expenses - airfare, accommodation, meals, entertainment etc..
• Furniture and equipment.
• Business cards, stationery and office supplies.
• Parking fees.
• Bank fees on business accounts.
For more detailed treatment of each of these deductions, as well as many others, visit the IRS website at http://www.irs.gov.
Tax time is no fun for any of us but there is no reason to make it any harder than it has to be. If you keep putting off getting your tax return prepared because you just can't face the thought of going through that shoe box at the back of your closet to organize your receipts, make a vow that this is the last year you will do this to yourself. It's still early enough in the year to get your act together and by this time next year you could be focusing on your business rather than stressing out about something as unnecessary as tax-time hassles.
Elena Fawkner is editor of the award-winning weekly ezine, A Home-Based Business Online, a down-to-earth publication containing practical home-based and online business ideas, telecommuting job listings, original articles, free e-books and much more. She also runs the A Home-Based Business Online website at at http://www.fawkner.com. You can subscribe to her newsletter at the site.