Tax time is fast approaching, and if this is a question you’ve asked yourself over the past year, the Internal Revenue Service (IRS) may be asking it too — and soon.
The Difference Between Commerce and Hobby Status
The IRS defines a hobby as an activity not engaged in for profit. That may still allow for some grey area if you’re just getting started in business, but many of the specific guidelines posted on the IRS’s site don’t. To qualify as a business, your activities have to start showing a profit some time, so if you’re woodworking, quilting, or scrapbooking business is operating in the red even though you’re having a great time (you did print up those business cards and stationery), there may be cause for concern. According to the IRS, improperly claiming a hobby as a business accounts for some of the $30 billion in back taxes assessed every year. Here are the rules and limitations you should familiarize yourself with before your file your tax return:
Profitability – One big stumbling block in claiming deductions for quasi-businesses is that the IRS expects businesses to see a profit in three out of five years of operation. If you’re just starting out, this allows you some wiggle room to get up and rolling. It also allows you a grace period if you started a business in a booming economy and the boom faded, but there’s likely to be a turnaround — hopefully soon.
Allowable Expenses – When it comes to allowed expenses, what others are doing in your field impacts what’s accepted as an appropriate deduction. The IRS puts it this way: “In general, taxpayers may deduct ordinary and necessary expenses for conducting a trade or business.” Ordinary expenses are defined as those considered accepted for the industry or trade in which the business is actively involved.
Here are other guidelines the IRS uses to make its determination:
- Do your activities show that you have the intention of making a profit? This often equates to the time and effort involved in building your business over the course of the year.
- Do you rely on the monies earned from the business? If you need the income from the business, you’ve probably met the criteria.
- Are losses sustained by the business explainable as beyond your control, due to necessary startup costs, or the result of measures taken to improve your overall profitability? (Remember the five year rule mentioned above.)
- Do you (or the people advising you) have the necessary knowledge to make the business successful? Have you, say, made money in this type of business in the past?
- In the future, do you expect to make a profit from the appreciation of the assets used in your business?
If you still have some doubts about your status, the IRS has a business expense publication you can review for more details. It includes a section about what’s new for the 2011 tax year. You can find it at: http://www.irs.gov/pub/irs-pdf/p535.pdf.