Hobby Business Tax Rules

Be ready to prove that your hobby is a business if you want to write off your losses.

Often a person's hobby or sideline business is a labor of love rather than a reliable source of income. This is most often the case when the business owner or freelancer has other means of financial support -- such as a regular job or a working spouse -- that effectively underwrites the microbusiness. These types of tiny businesses are usually run from home (renting an office would be too expensive) and are often based on semi-recreational activities near and dear to the owner, which has earned them the nickname "hobby businesses."

There are as many types of hobby businesses as there are hobbies. A basement jewelry studio, a jazz band for hire, or an antique refinishing business might all qualify. The owners would probably continue to make jewelry, play jazz, or restore antiques without making money, but they are trying to turn their hobbies into profitable businesses -- or at least deduct their hobby-related expenses or losses from their income to lower their tax bill!

Deducting Hobby Losses From Your Income

For most business owners, losing money for more than a year or so is a cue to close up shop. But if you love what you're doing, it might make sense for you to stick with your business even though it makes little or no money. That's because an unprofitable business can be a tax shelter: If you have another source of income, you may be able to use the losses from your hobby business -- including your expenses and depreciation on assets you purchase -- to offset your other taxable income. Deducting these losses can not only lower the amount of income on which taxes are owed, but also drop you into a lower tax bracket.

The catch is that only bona fide businesses can deduct their losses from their other income -- you're not allowed to deduct losses from your favorite activities, only from a legitimate, profit-motivated business. If the IRS decides that you are indulging a hobby rather than trying to earn a profit, it won't allow you to deduct your business losses.

Example

Reza earns a salary as a chef in a local restaurant, and his wife Kay has no outside income. They file a joint tax return. Kay has a passion for plants, and decides to try making a business of selling some of the hundreds of plants she grows and propagates in her backyard greenhouse. After she spends thousands of dollars on exotic plants, better lighting equipment, and permits, the greenhouse heater goes on the fritz and many of her plants die. Her expenses for the year total $10,000, and she has sold only $200 worth of plants.

The silver lining for Kay and Reza comes at tax time, when they deduct the $9,800 loss from their joint taxable income of $65,000. By reducing their joint taxable income to $55,200, they not only are taxed on less income, but their tax bracket is reduced from 25% to 15%.

Here's the catch: If Kay had not intended to make a profit -- that is, if she wasn't trying to run a business -- the IRS would not have allowed Kay to use the loss to offset any income, except against the $200 revenue she received from plant sales.

Of course, most entrepreneurs would much rather make money by earning a healthy profit rather than by taking tax deductions because their business is losing money. And the savings made possible by a tax shelter do not always justify continuing a marginal or losing business. But they definitely can make a difference when you're deciding whether or not it's worth it to keep spending money on your hobby.

Proving That Your Hobby Is a Business

If you consistently use your business as a tax shelter, deducting your losses from your other income year after year, you'll probably attract the attention of the IRS. Make sure that the IRS will consider you a real business in case you're ever audited, before you start claiming deductions for the costs of your art projects or toy car collection.

The deciding factor in determining whether a business is legitimate is whether the activity is engaged in "for profit." In other words, you must prove to the IRS that you're trying -- not necessarily succeeding -- to make a profit with your venture. The IRS uses several different criteria for deciding whether or not your business truly has a profit motive.

One popular test for determining profit motive is called the "3-of-5" test. If your business makes a profit in any three out of the past five consecutive years, it is presumed to have a profit motive. This means that if you claim a loss for the third straight year after starting your business, you may be inviting an audit.

While the IRS gives a lot of weight to the 3-of-5 test, it is not conclusive. In other words, if you flunk the 3-of-5 test, you still may be able to prove that your business is motivated by profit. You can use virtually any kind of evidence to show that you're trying to make money.

Business cards, a well-maintained set of books, a separate business bank account, current business licenses and permits, and advertising or other marketing efforts will all help to persuade an IRS auditor that your activity really is a business.

Complying With Local Business Rules

Many cities require every local business to obtain a business license or tax registration certificate. Technically, this rule applies to any money-making activity -- even if you don't intend to claim any federal or state tax deductions for your hobby business. Also, if you sell goods (such as homemade jewelry), your sales will be subject to state sales taxes, which means you'll have to apply for a "seller's permit."

In practice, many microbusinesses -- so tiny that the word "business" seems excessive -- might be able to fly under these agencies' radar. But be aware that, depending on your local rules, you could be penalized if you're caught doing business without the licenses or permits required by your state or local government. These penalties may include fines and any back taxes that apply.

In addition, getting the necessary licenses and permits will help show the IRS that you really are running a business. For more information, see Obtaining Licenses and Permits.

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