Do You Have A Business? Or Is It A Hobby? - John R. Dundon II, Enrolled Agent
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Do You Have A Business? Or Is It A Hobby?

Do You Have A Business? Or Is It A Hobby?

The IRS has developed a rule of thumb for analyzing business losses called the Hobby Loss Rule of Thumb that basically says if a business reports a net profit in 3 out of the last 5 years it is presumed to be a for-profit business. Similarly if a business reports a net loss in more than 2 out of the last 5 years it is presumed to be a not-for-profit hobby.  Whether you have a business or a hobby is important to the IRS because your hobby expenses are only deductible up to hobby revenue each year and additional losses cannot be carried to another tax year to offset gains like they could if you had a business.

In that most new businesses often incur losses at first, it is quite common for a business to have a year or two of losses before becoming profitable. In fact I have seen MANY businesses with several years of losses before ever making a profit. Generally speaking the burden of proof as to whether you are in a business or just have an expensive hobby is on you the tax payer. So be sure to document everything that can help demonstrate your profit motive. You can also prove your profit motive using the following nine factors listed in IRS Publication 535 Business Expenses:

  1. You carry on the activity in a businesslike manner.  To determine this ask yourself questions like, do you have customers? Do you have suppliers? Do you make anything? What do you sell? Do you have letterhead and a business card? How do you keep and reconcile your financial records? Do you have an Taxpayer Identification Number? How are you structured organizationally?

  2. The time and effort you put into the activity indicate you intend to make it profitable. How much personal time and energy do you spend on the venture? What personal sacrifices are you making to the betterment of the venture?

  3. You depend on income from the activity for your livelihood.

  4. Your losses are due to circumstances beyond your control or are normal in the start-up phase of your business.

  5. You change your methods of operation in an attempt to improve profitability.  How do you document operational procedures?

  6. You, or your advisers, have the knowledge needed to carry on the activity as a successful business.

  7. You were successful in making a profit in similar activities in the past.

  8. The activity makes a profit in some years, and how much profit it makes, and

  9. You can expect to make a future profit from the appreciation of the assets used in the activity.

An audit to defend your business losses involves a relatively detailed review of your income and your expenses for your business. The IRS Examiner will examine your accounting records, receipts, invoices and bank statements looking for income that might be unreported or deductions that might be overstated. The IRS may also question whether certain expenses are directly related to your business. Demonstrate that you are in business for yourself, and you will succeed in defending your business losses against an IRS examination.

I think the bottom line is that if you really have a business you are best served to have a separate and distinct taxpayer identification number with the IRS regardless of your business structure.  For whatever it is worth as of today I have not encountered a single situation where the IRS believed that an entity structured as a corporation was actually a hobby so in addition to getting the taxpayer ID number, consider incorporating as a sub-chapter S corporation.