Is it a hobby or a business?

If you are like me and many of my clients you may be involved in some activity beyond your normal primary income source. Maybe you do some woodworking like I do, or maybe you got involved in a multi-level marketing organization.

Whether this activity is considered a bona fide business or is deemed to be a hobby can have significant tax implications for the taxpayer.

The IRS has set forth guidelines to assist in determining whether an activity is considered a business or must be classified as a hobby, which is an activity not engaged in for profit.

In order to educate taxpayers the IRS has put forth specific rules to help explain the classification of an activity as a business and what tax deduction limitations exist if the activity is not a business. Incorrect deduction of hobby expenses can expose the taxpayer under audit to back taxes, penalties and interest, and ultimately costs the government billions of dollars in tax receipts.

The general rule of thumb for the deduction of expenses through a business is that all ordinary and necessary expenses may be deducted in relation to conducting a trade or business. An ordinary expense is one that is considered common and accepted in the taxpayer’s trade or business. A necessary expense is deemed to be one that is appropriate for the business.

Generally an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit.

Some factors that the IRS has set forth to help in this determination are the following:

• 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?

The IRS further presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years including the current tax year.

If an activity is deemed to be a hobby, losses from that activity may not be used to offset other income. An activity where the expenses exceed the income produces a loss. This limit on losses applies to individuals, partnerships, estates, trusts, and S Corporations. So, even if you form a separate legal entity these same hobby loss limitation rules apply.

So, for instance the businesses that are based on house parties such as Pampered Chef, Tupperware or Creative Memories are an example of the type of activity that the IRS might target. The taxpayer works full time in a position, but has an interest in this product. They start a “business” and experience ongoing losses. The question the IRS asks is whether this is a legitimate business with a profit motive or someone’s hobby.

I, for one, would love to write off the cost of my woodshop as a tax deduction since I occasionally sell my woodworking. However, the IRS would classify my activity as a hobby and disallow the deduction.

So be careful when you are deducting your side interests as a business expense as the IRS can, and will, come back and disallow the deductions and classify the activity as a hobby. Unless you feel that you can appropriately answer the above questions then you should avoid being overly aggressive and taking this type of deduction so that you can sleep easy knowing the IRS will not come knocking at your door. Paul Pahoresky is a partner in the accounting firm of JLP CPAs. He can be reached at 440-974-1040 x14 or at paul@jlpcpas. com. Consult your tax advisor for your specific situation for additional information and guidance on these topics.