When Is Your Small Business Really a Hobby?

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If you decide to run a business from your home, you better make sure you take it seriously or you could be facing a sticky tax situation.

One tax court case provides a textbook example of how not to operate a direct sales business. Brenda Konchar reported net losses for her Mary Kay direct sales “business” for several consecutive years. The IRS disallowed the losses, stating that the activity was a hobby and not a trade or business entered into for profit. Even if the activity had been conducted with a profit motive, most of the business expenses she claimed could not be substantiated.

The Tax Court agreed with the IRS that the activity was a hobby and not a business. Under §183(b), if an activity is not engaged in for profit, expenses are generally only deductible to the extent of the gross income from the activity. You can't deduct expenses in excess of your income.

The Court determined that the taxpayer did not intend to make a profit in her Mary Kay activity because:

  1. She did not conduct the activity as a business. She did not maintain a separate checking account or have business cards.
  2. The deduction for returns and allowances plus cost of goods sold exceeded her gross receipts, indicating that she was selling her products at or near cost.
  3. There was an element of personal pleasure in the activity, as most of her customers were family and friends. She took huge business mileage deductions for long distance travel to visit these customers for business and personal reasons.
  4. She had no experience in operating her own business and did not seek any professional advice.
  5. She claimed large losses each year and never developed a plan to improve the activity’s profitability.

It is very important to pass the “duck test” (if it walks like a duck and quacks like a duck, it is a duck) when it comes to operating a business as a direct seller of Mary Kay, Tupperware, Avon, etc. So, what should you do?

Firs, it couldn’t hurt to form an LLC for your business.

When setting up your business, keep in mind that it should be treated as a separate entity:

  • Open a checking account in the name of the business. Do not use your personal checking account to pay business expenses.
  • Open a charge account in the business name at Staples, Office Depot or Office Max.
  • Keep a mileage log to record business trips.
  • Create an expense report form with the name of the business on it and use it to identify business mileage and expenses for which you will reimburse yourself from the business checking account.
  • Keep a set of books for the business. This can be done easily with “general ledger” software like Microsoft Money.
  • Have business stationery, letterhead, billhead and business cards printed. The Tax Court specifically mentioned that Konchar did not have business cards. This can be cheaply and easily done via Microsoft Word and a simple business card software program.
  • Solicit clients from beyond your circle of family and friends. You can put business cards or flyers on various public bulletin boards, such as in supermarkets, and take a photograph of your notice appearing on the bulletin board as proof just in case.
  • While you can offer discounts and special promotions you should charge reasonable prices for your products that are close to market. Don’t give them away at cost! This is a sure sign that you are not in business to make a profit, but are only involved in the activity to buy stuff for yourself and your family and friends below market prices.
  • Before starting any type of business, make an appointment with your tax pro and spend some time going over how to operate the business. Then, if you are audited, you can show the IRS that you sought professional help in establishing the business.

It is vitally important that you keep good records of all business income and expenses.  Maintain proper documentation for business purchases and expenses.

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