Small home-based businesses have been touted as the last great opportunity for tax shelter. Maybe they are, but there are rules requiring that your business actually be a business and not merely a hobby for which you bring in a little cash to help cover costs.
Hobby Loss Rules
A Hobby Loss is a loss incurred in an activity that has some appearance of being a business, but which the taxpayer is not engaged in for profit. If an activity is deemed by the IRS to be a hobby, then deductions are only allowed to the extent of gross receipts. In other words, you cannot deduct a loss against other categories of income.
If a taxpayer engages in two or more activities, the costs incurred must be allocated among the activities in a rational manner that is consistently applied.
Presumption of a Profit
The good news is that an activity that generates a profit is presumed to be a business and not a hobby. To qualify under this standard, the activity must have generated a profit in three of the preceding five tax years.
Factors Listed in Regulations
The regulations list 9 factors to consider in determining whether an activity is engaged in for profit:
- The manner in which the taxpayer conducts the activity
- The expertise of the taxpayer or his advisors
- The time and effort spent on the activity
- The expectation that assets used in the activity may appreciate
- The taxpayer’s success in similar activities
- The taxpayer’s history of income or losses in the activity
- The amount of profits
- The taxpayer’s finances
- Elements of personal pleasure or recreation associated with the activity
Ways to Reinforce Your Position
- Prepare a comprehensive business plan
- Always refer to your business in ways that reflect your profit objective
- Keep books of the type that a for-profit business would keep
- Carry out promotional activities aimed at generating growth
- Seek to improve your knowledge of the business
- Spend a reasonable amount of time working the business
Activities Often Targeted as Hobbies
- Collecting antiques, coins, stamps, etc.
- Raising thoroughbred dogs and horses
- Publishing pamphlets in philosophy
- Travel writing
- Auto racing
The above activities can be engaged in for a profit, but when the taxpayer has other sources of income, these look particularly suspicious.