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Is Your Business Really a Business?

Having a small business can be beneficial come tax time, allowing you to deduct many of your losses and expenses. But you need to be careful, because you can’t just claim that any activity is a business. There are rules that help determine whether your business is actually a business, or just a hobby that happens to bring in a little bit of cash. Here are a few tips that will help you identify the status of your activities, and what impact they will have.

Why This Matters: Hobby Loss Rules

The reason that it is important that your business is actually a business, and not just a hobby, is because the financial rules for hobbies and businesses are very different. The so-called Hobby Loss rules regulate rules for the finances of activities that might on the surface appear to be businesses, but are legally viewed as hobbies. These activities are classified as hobbies because you’re not engaged in them for profit, at least in the eyes of the law. When you lose money while engaged in these activities, you are only allowed to deduct losses equal to your gross receipts. Your losses cannot be deducted against other categories of income.

Presumption of a Profit

The primary distinction between a business and a hobby is the presumption of a profit. If an activity generates a profit, then it’s presumably a business, and not a hobby. You have to generate a profit three out of the last five tax years for your activity to qualify as a business under this standard. There are a number of other factors, though, that can help determine whether you’re in a for-profit business or a hobby. Regulations give nine factors; think about how they might apply to your activity:

The manner in which you conduct the activity;
Your expertise in the subject;
Time and money you spend on the activity;
Any expectations that the activity’s assets will appreciate;
Your prior success in similar activities;
Your history of income or losses in the activity;
The amount of profits the activity brings in;
Your personal finances;
Personal pleasure or elements of recreation associated with the activity.

Improving Your Position

There are specific steps you can take to improve your position, and help ensure that your business is actually a business, and not legally viewed as a hobby. First, prepare a comprehensive business plan, and whenever you refer to your business, make sure it’s clear that your goal is profit. Treat your business like a business. Keep record books the same way that a for-profit business keeps them, and have promotional activities to generate growth. Participate in educational opportunities that improve your knowledge of the business, and devote a fair amount of time to it. If you treat your activities like a hobby, then the IRS will do the same.

Be particularly careful if you’re engaged in an activity that is commonly considered a hobby. Make it abundantly clear that your business is different and goes beyond the activities of a hobbyist. Some examples of these oft-targeted activities include collecting antiques, coins, and stamps; raising thoroughbred dogs and horses; publishing philosophy pamphlets; travel writing; and auto racing. These are all activities that you can do for profit, but they can also be just a hobby, and as a result they get extra attention from the IRS.

Published: December 17, 2012
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Chris Barnes

Chris Barnes is the Director of Business Development at Tarkenton Companies, with a sales and marketing background in a wide range of industries, from sports information to insurance marketing. A jack-of-all-trades, Chris has experience in many aspects of daily and strategic operations for small business.