Business or Hobby? It’s All About Taxes

Many successful businesses began in garages or around kitchen tables. And many businesses lose money in their early years. However, some ventures that begin with business aspirations never make money and turn into expensive hobbies.

The difference between a money-losing business and a hobby is important at tax time, because you may be able to deduct business losses from other income to help reduce your tax burden. But you cannot deduct hobby expenses.

IMAGE of a couple doing an inventory on a laptop with shipping boxes next to them

Working for Profit

In order to qualify as a business, the activity must be operated with the intention and potential to earn a profit, even if it is not profitable every year. For any given tax year, the IRS will presume that your activity is operated for profit if it has earned a profit in three of the previous five years, including the current year. If you are just starting your business, you can file Form 5213 and request that the determination be delayed until you have five years of business experience.

If your activity does not pass the three-year profitability test, the IRS will take into account all facts and circumstances regarding the activity in order to determine whether you can deduct business losses from other income. These are some questions you should consider, but no single factor is decisive.

  • Do you run the activity in a businesslike manner and maintain complete and accurate books and records?
  • Does the time and effort you put into the activity indicate you intend to make it profitable?
  • Do you depend on income from the activity for your livelihood?
  • Are your losses due to circumstances beyond your control, and/or are they normal in the startup phase of your type of business?
  • Have you changed your methods of operation in an attempt to improve profitability?
  • Do you or your advisers have the knowledge needed to carry on the activity as a successful business?
  • Have you been successful in making a profit in similar activities in the past?
  • Does the activity make a profit in some years, and how much profit does it make?
  • Can you expect to make a future profit from the appreciation of the assets used in the activity?

Keep in mind that even a small-scale activity that you pursue on evenings and weekends, or after retirement from your regular job, might be considered a business as long as the IRS determines it is operated for profit. For more information, see IRS Publication 535, Business Expenses.

 
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