Mind if I bore you to tears for a little bit?

Talking about taxes is no fun (kind of like having a root canal with no laughing gas). Matter of fact, it is stressful, but we must. With the new year (and tax season) right around the corner, it is time to get our financial houses in order. There seems to be a lot of confusion about whether an activity we are pursuing should be viewed as a small business versus a hobby. The Internal Revenue Service (IRS) assumes that if you start a business, you intend to make money at it. If this is not the intention, your business is likely to be a hobby. Taxpayers often get confused when their hobby suddenly begins to generate some income and immediately classify it as a small business. The IRS defines a hobby as any activity “for sport or recreation, not to make a profit.” While this is still not entirely clear for some, the key consideration is intent.

In the eyes of the IRS, here are some general guidelines for determining a hobby vs. a business (Source: Internal Revenue Service, IRS). Ask yourselves these questions:

• Does the time and effort put into the activity indicate an intention to make a profit?
• Does the taxpayer depend on income from the activity?
• If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
• Has the taxpayer changed methods of operation to improve profitability?
• Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
• Has the taxpayer made a profit in similar activities in the past?
• Does the activity make a profit in some years?
• Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?

If you are legitimately operating a side business, it should be treated as such.

One sure way to determine if your activity is actually a hobby is that shows a consistent net loss over several years (known as “hobby loss”). But be warned, running a hobby as a business could potentially raise eyebrows and result in an audit. Whereas, an activity that demonstrates a profit over the course of at least 3 of the last 5 tax years is operating more like a business. In which case, be sure to keep accurate records (i.e., receipts, records, business plans) to prove that you are indeed operating a legitimate profitable business. As before mentioned, reporting losses during the initial startup phase is normal, but persistent losses over the course of a few years could result in the IRS classifying it as a hobby.

I hope I made the muddied waters a bit clearer!