If you are self-employed or have a side business where you have not turned a profit in some time, if ever; you may need to consider whether you’re actually running a business for tax purposes. If you have a business that is continually taking a loss, you may, in the eyes of the Internal Revenue Service (IRS) have a hobby, not a business.
The bottom line difference between a hobby and a business, for tax purposes, is that a business may write off or deduct its expenses and losses. A hobby may not be able to deduct those losses. Therefore, if the government determines that your business venture is actually a hobby, then you will likely need help with the IRS. Therefore, if you have a venture that is not quite turning a profit, you need to take steps to protect your business’ status as a business venture in the event you are audited.
The real determination to be made is whether the venture is being operated with a reasonable expectation of making a profit. The analysis is fact intensive on a case-by-case basis. In virtually all cases the government will start its analysis by looking at your business’ earning history.
Generally, there is a presumption that a for-profit business (not a hobby) will have turned a profit in three of the preceding five years. However, there are other factors that can be persuasive even when a business cannot meet this presumption. Here are some of the factors that may be considered during a tax audit review:
• What is the time and effort put into the venture by the owner?
• Does the venture and/or owner have the appropriate licenses required to operate as a business of its type?
• Is the venture still in its start-up phase?
• Are financial losses incurred by the venture beyond its control?
• Has the venture changed methods of operation to improve profitability?
• Does owner or its advisors have the knowledge needed to carry on the activity as a successful business?
• Has the owner made a profit in similar activities in the past?
• Has the venture ever made a profit?
• Can the owner expect to make a profit in the future from the appreciation of assets owned or used by the business?
Since the government’s analysis is supposed to be case specific, there may be additional factors considered should they be presented properly. The bottom line is that if your business is just on the brink of making a profit, be sure to do the things necessary to prove it’s actually a business, and not a hobby; to ensure that you don’t pay more than your fair share in taxes.
This article is not intended as legal advice, and cannot be relied upon for any purpose without the services of a qualified professional.