A Business or Just A Hobby?
Many people in our area are involved in other activities outside of their regular jobs that ostensibly could be considered a business.
Our communities, for instance, are filled with antique malls and flea markets where people rent booth space to sell their treasures. Other common examples might include folks who are fishing guides or own livestock.
Because businesses are allowed to deducted related expenses and sometimes may produce a loss that could offset other taxable income, the IRS may question whether an activity really is a business or merely a hobby.
This is important because if the activity is deemed a hobby (i.e., not really engaged in for profit), tax law limits the activity's deductible expenses to the amount of income it generates. In other words, it is not allowed to generate a loss that can be used against other sources of taxable income.
Further, whatever expenses are allowed are not deductible directly against the activity's income, but are deemed miscellaneous itemized deductions that are only deductible if you actually itemize deductions and further only to the extent they exceed in total 2% of adjusted gross income (AGI).
So, for instance, someone who takes the standard deduction would get no benefit at all from those deductions.
There are nine factors listed in regulations for determining if something is a hobby or a business. Those factors are:
1. How you carry on the activity. Another way of saying it is whether you conduct the activity in a businesslike manner. You can establish this by maintaining separate personal and business bank accounts, keeping books and records, and acting like similar profitable businesses.
2. Your level of expertise. You should have extensive knowledge of your activity, showing that you have studied accepted business methods and sought advice from experts.
3. The time and effort you expend in carrying out the activity. Is the amount of time you spend on the activity indicative that you have an actual and honest objective of making a profit?
4. An expectation that assets used in the activity may appreciate in value. Regulations say expectation of appreciation in the value of assets (e.g., land) may be considered as profit motive in lieu of current profits.
5. Success in other activities. Even if the activity is currently unprofitable, it may be for-profit if you have converted other activities from unprofitable to profitable in the past, especially ones similar to the current activity.
6. History of income or losses from the activity. Businesses sometimes incur losses; that's just reality, so incurring losses alone are not conclusive. However, a long string of losses may indicate hobby status, whereas a history of income indicates a for-profit activity.
7. The relative amounts of profits and losses. Regulations state that "The amount of profits in relation to the amount of losses incurred, and in relation to the amount of the taxpayer's investment and the value of the assets used in the activity, may provide useful criteria in determining the taxpayer's intent." In other words, a tiny profit one year followed by big losses in other years is not a good sign.
However, the law also says that if an activity has gross income that exceeds deductions for three or more of the last five years (three out of seven for a farm), the activity generally is presumed to be for-profit.
8. Your financial status. Having other significant sources of income does not preclude an activity from being considered for-profit, but they may indicate the activity is a hobby. In other words, if you really make your living another way, and don't rely on the activity to help pay your bills, it might be a hobby.
9. Whether the activity provides recreation or involves "personal motives." This may, with other factors, indicate lack of a profit motive. For instance, raising horses because you like them might be a problem, whereas running a lawn service probably is not.
While these factors are critical considerations, it is important to note that no single fact pattern or factor is conclusive and that all the facts and circumstances must be considered.
However, by knowing these factors, you can take steps to lessen the chance that your activity could be deemed a hobby, potentially causing your tax bill to rise.
