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Hobby vs. Business: Avoiding the Hobby Loss Rules

You might be surprised to learn that, as a business owner, you actually have to prove to the IRS that you’re in business to make a profit. If the IRS determines that the activity that you think of as your business is not actually a business, but a hobby, the tax consequences can be disastrous. The reason for this distinction is that the IRS does not want taxpayers to be able to engage in activities primarily for fun, and then simply call the activity a business and attempt to deduct the related expenses.

Ramifications of Your Business Being Treated as a Hobby

Should it be determined that your business is going to be treated as a hobby for tax purposes, your ability to take deductions will be severely limited. First, any deductions that you take will no longer be treated as Schedule C deductions; they will become itemized deductions (thus only benefiting you if they, along with your other itemized deductions, exceed your standard deduction).

In addition, the itemized deductions are included in the type known as “miscellaneous” itemized deductions. What this means is that they can only be deducted to the extent that they exceed 2% of your Adjusted Gross Income (basically your taxable income minus any above the line deductions).

Finally, the deductions you can take for the activity are limited to your income from the activity. As such, if you have a loss from your business/hobby, you won’t be able to use it to reduce your taxable income from other sources.

How to Make Sure Your Business Isn’t Ruled to Be a Hobby

Fortunately, there are several things you can do (and are probably already doing) that can help you prove to the IRS that you are in fact running a for-profit business. The most important thing you could do is to actually earn a profit. If your activity has earned a profit for three of the last five years, it is presumed to be a for-profit business.

If your activity has thus far been unprofitable, or if you just started your business, there are a number of other factors that are considered before it is declared that your business is in fact a hobby:

  • How much time and effort do you put into the activity? (The more, the better.)
  • Do you depend on the activity for income?
  • Do you conduct the activity in a business-like manner? (Having business cards and customized letterhead, for example, will help with this.)
  • Do you have the level of expertise necessary to be able to earn a profit from the activity?
  • Do you regularly improve upon your processes in order to improve your profitability?
  • Have you made a profit with similar activities in the past?
  • Were the majority of the years with losses during the start-up phase of the business, or were the losses due to circumstances beyond your control?

Simple Summary

  • If the IRS declares that your business is really just a hobby, the tax consequences will be quite unfortunate. Your business deductions will suddenly become itemized deductions, and will be limited to your hobby income.
  • The best thing you can do to avoid hobby classification is to earn a profit with your business.
  • Even if you don’t earn a profit, if you make sure to run things professionally, you’re more likely to avoid hobby classification.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
  • Self-employment tax: What it is, why it exists, and how to calculate it,
  • Business retirement plans: What the different types are, and which one is best for you,
  • Click here to see the full list.
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