When you incorrectly claim your favorite hobby as a small business, it’s like waving a red flag that says “Audit Me!” to the IRS. However, there are tax benefits if you can correctly categorize your activity as a small business.
Why does hobby versus business activity matter?
Chiefly, you’re allowed to reduce your taxable income by the amount of your qualified business expenses, even if your business activity results in a loss.
On the other hand, you cannot deduct losses from hobby activities. Hobby expenses are treated as miscellaneous itemized deductions and don’t reduce taxable income until they (and other miscellaneous expenses) surpass 2 percent of your adjusted gross income.
Here are some tips to determine whether you can define your activity as a business.
|You have a reasonable expectation of making a profit.||Profit Motive||You may sell occasionally, but making money is not your main goal.|
|You invest significant personal time and effort. You depend on the resulting income.||Effort and Income||It’s something you do in your free time; you make the bulk of your money elsewhere.|
|Your expenses are ordinary and necessary to run your business.||Reasonable Expenses||Your expenses are driven by your personal preferences and not strictly necessary.|
|You have a track record in this industry, and/or a history of making profits.||Background||You don’t have professional training in the field and have rarely or never turned a profit.|
|You have multiple customers or professional clients.||Customers||You have few customers, mainly relatives and friends.|
|You keep professional records, including a separate checkbook and balance sheet; you have business cards, stationery and a branded business website.||Professionalism||You don’t keep strict professional records of your activities; you don’t have a formal business website or business cards.|
The IRS will consider all these factors to make a broad determination whether you operate your activity in a businesslike manner. If you need help ensuring you meet these criteria, reach out to schedule an appointment.