Every now and then, as a CPA, you run into a person who tells you they want to start a business in order to sell say…old collectibles, creative photos they’ve taken, or their DIY crafts. While sometimes these endeavors can turn into a viable business, in some cases, these individuals are really expressing a greater desire to unload their belongings than an actual intention to build value and increase personal earnings year to year. And some are just looking for a tax deduction for an expensive recreational activity.
For the purpose of filing a tax return, it is important to understand the differences between running a viable business and conducting a hobby, as confusion over the distinction can lead to accidental noncompliance with the IRS hobby loss rules.
An activity is presumed to be a business if income exceeds deductions for 3 or more out of 5 consecutive years. Although not an exclusive list, the below facts and circumstances are a few additional considerations to determine if there is a profit motive intended.
- Keep separate personal and business bank accounts and records
- Have an extensive knowledge and seek advice from advisors
- Time and effort need to exemplify an honest objective of making a profit
- Success in running a prior business and turning it from unprofitable to profitable
- Personal motives outweigh recreational aspects
- Keep track of personal versus business use of assets
And why does this all matter? Well…If you have a hobby, rather than a business, ordinary and necessary expenses are deductible. However, hobby expenses are only allowed to be deducted up to the amount of income from the activity, and losses cannot be deducted from other income.
The IRS can challenge your profit motive presumption if your profits are small compared to your losses as well. If your intent is to run a business, we recommend you develop a written business plan and update it annually. It is also recommended that you evaluate operations regularly and document results in order to improve profitability.