Daily Deduction: Is it a Hobby or a Business?

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Have you ever considered turning your hobby into a business on the side so that you could deduct the expenses? For instance, if you become an aspiring professional rock climber, actress or weekend charter boat captain, can you deduct the cost of your life jacket, cleats and theater lessons? Most people think so, but Daily Deduction readers should know a “too good to be true” tax break when they see one. If your splashy new venture will never turn a profit, you shouldn’t deduct the cost of your personal fishing gear to cover the loss.

In general, you can deduct ordinary expenses associated with running a business even if those expenses exceed the amount of money that your venture earns. If your alleged business is really a hobby, though, stricter rules apply. Instead of being able to deduct all of the costs associated with your activity, you can only deduct them to the extent that they don’t exceed your profit. For example, if it costs $3,000 to keep your pet alpacas fuzzy and fed, and you earn $1,000 by selling their wool, you can deduct $1,000 of your $3,000 expense. But you can’t deduct the other $2,000, because your activity is a hobby rather than a business.

(Read this story about how one guy turned a frustrating commute and an interest in technology into a profitable small business.)

How can you tell the two apart? An activity usually qualifies as a business if it has reasonable chance of making a profit. The IRS uses a number of distinguishing factors to make the difference clear. Your activity is probably a business, rather than a hobby, if some of the following things are true:

  • You put a significant amount of time and effort into your activity.
  • You depend on your activity for income.
  • Losses from your activity are due to circumstances beyond your control, or they are a natural result of your business’s startup period.
  • You change your operations in response to losses in order to make your activity more profitable.
  • You consult advisers about how to improve your profitability.
  • You have made a profit from similar activities in the past.
  • Your activity makes a profit in some years, even if it doesn’t do so well in others. In other words, your business is not completely hopeless.

If you’re concerned that the IRS might limit your deductions by mistaking your business for a hobby, you can take preventive actions based on the list of factors above.

1. Keep good records. Maintaining accurate records of your income and expenses demonstrates that you are concerned with the profit potential of your business.

2. Ask an expert. Seek advice on how to maximize your profit, and use that advice to develop a business plan.  A business plan can prove to the IRS that you take your business seriously and have a strategy for making money. 

3. Learn from your mistakes. If your business does poorly in one year, correct your course in the next year. It may be less fun to do things differently, but acting like a true owner and manager can make a big difference on tax day. 

4. Go forth and earn. If you make a profit for three out of five years in a row, the IRS will simply assume that your activity is a business, and no additional proof will be required.

If you dream of one day turning your hobby into your vocation, don’t let a lack of tax planning spoil your fun. By taking some simple, business-first steps, you can take full advantage of the business expense deduction. And if you just happen to earn a few extra hobby dollars along the way, don’t forget to deduct any expenses that don’t exceed the amount of your earnings.

Want to learn more about the tax ins and outs of your business?  Check out our complete archive of Daily Deductions.

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