For federal tax purposes, the determination of
"business" or "hobby" is a matter of deduction. If your new
venture is considered a business, you can deduct losses against other income.
However, when the activity is classified as a hobby, the
"hobby loss" rules limit the amount you can write off. Expenses you
incur might be deductible only if you itemize - or they might even be
nondeductible.
The distinction affects the amount of tax you owe. So how
can you prove you're trying to run a money-making business despite several
years of losses?
One test you're probably familiar with is the general rule
of earning a profit in three of the past five years. If your business has more
income than deductions in three of five consecutive taxable years, the IRS
generally accepts that you have a profit motive. (The time frame is two years
in seven for certain horse-related activities.)
Unable to meet that test? Additional factors play a role as
well. For instance, the Tax Court agreed that a volleyball consulting service
with multiple loss years qualified as a business, in part because of a
businesslike manner of operation. Among other items, the Court mentioned the
maintenance of a separate bank account and accurate records as support for a
profit motive.
Positive indicators of your profit-making intentions also
include your expertise in the activity, the time and effort you put into your
new business, and your success in other ventures.
If you'd like a complete list of the IRS "business vs.
hobby" criteria, please contact us. We'll be happy to review the
guidelines with you.
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