Operating your own business has many benefits. In addition to being your own boss, there are numerous tax deductions you can take for expenses created by business operations. Those can include use of your home for business, supplies, vehicle expenses, utilities as well as travel, meals, and entertainment just to name a few. They’re often expenses that you could not otherwise deduct to lower your tax liability.
Many entrepreneurs launch their businesses as a result of their hobbies. For example, John enjoys woodworking and begins making cabinets. He renovates his kitchen with the cabinets he made. Family and friends comment on how great they are – good looking with quality craftsmanship. John makes cabinets for his parents, and folks suggest he should start his own business. So he starts making and selling cabinets on the side. Since he’s just starting out, it’s not unusual that he operates at a loss. He has to buy additional tools, lumber, hardware, and other supplies and hasn’t yet covered those expenses with what he’s earned so far (i.e. profit).
Can John declare a loss and use it as a deduction from other income? It all depends on whether John is engaged in a hobby or running a business.
If it’s the former, a hobby, expenses for his cabinet-making venture can only be deducted against John’s hobby income. So if his expenses for the year are $10,000 and he’s charged $7,500 for his cabinets, he can only deduct $7,500 in expenses and cannot take a $2,500 loss against his total income.
Business or Hobby Litmus Test
Now if John could declare that he’s running a cabinet-making business and not simply indulging in his woodworking hobby, he could claim the full loss against his total income for the year and could likely take additional deductions, like the expense for business use of his home workshop.
Hobby businesses like John’s can create a tax shelter by allowing owners to deduct losses against total income to reduce taxable income and very possibly drop them into a lower tax bracket. If there’s another source of income (e.g. full-time job or working spouse), that may seem like an attractive proposition; however, the IRS certainly has something to say about it, especially when someone deducts business losses year after year.
Before you decide to do that and venture down that troublesome path (huge red flag for an audit), you should ensure that the IRS will deem your own business to, in fact, be a business and not a hobby. In the hobby vs. business debate, the IRS does not have clear rules; however, it does have guidelines.
According to the IRS, “Internal Revenue Code Section 183(Activities Not Engaged in for Profit) limits deductions that can be claimed when an activity is not engaged in for profit. IRC 183 is sometimes referred to as the ‘hobby loss rule.’”
Proving You Have a Business
There are nine factors that are used to prove an entity is operating as a business and not a hobby:
- Whether you carry on the activity in a businesslike manner.
- Whether the time and effort you put into the activity indicate you intend to make it profitable.
- Whether you depend on income from the activity for your livelihood.
- Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
- Whether you change your methods of operation in an attempt to improve profitability.
- Whether you or your advisors have the knowledge needed to carry on the activity as a successful business.
- Whether you were successful in making a profit in similar activities in the past.
- Whether the activity makes a profit in some years and how much profit it makes.
- Whether you can expect to make a future profit from the appreciation of the assets used in the activity.
While someone indulged in a hobby might carry on activities in a businesslike manner, the remaining factors tend to focus on one word: profit. Granted, not every business is profitable every single year. The IRS has an allowance for this and states, “An activity is presumed for profit if it makes a profit in at least three of the last five tax years, including the current year.” (Note: For horse training, breeding, or racing, profitability must occur in two of the prior seven years.)
If it turns out that you have a hobby and not a business, allowable deductions can be claimed on Schedule A if you itemize but can never exceed your gross receipts.
So, are you working or having fun? If it’s the latter and you’re taking too many deductions, you could end up facing an audit and severe penalties. Contact us to discuss your situation. We’ll help you adhere to the law and can make suggestions to help you become more profitable as well.