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Taxation
101: Business Or Hobby?
Article by Elena
Fawkner
For many of us it's tax time again. For others, tax time is just
around the corner. So, how was business this year? Did you make a profit? If your
business is very new, most likely you took a loss. Oh well, at least you can write
it off, right? Well... maybe. Whether you can write off your business losses depends
on whether your business really is a business or a hobby. "Well, of course
it's a business!", I hear you say. "I don't put myself through this
for the fun of it!".
In this article we look, first of all, at the
things you need to be doing in your business to make it very clear to the IRS
that you are, indeed, running a business and not merely indulging in a hobby.
The reason this is so important is that although you have to declare and therefore
pay tax on the income you make from a hobby, you can't write off your losses and
may not even be able to deduct your expenses at all. Secondly, we'll take a look
at some of the common business tax deductions you should be thinking about in
the context of your business. Even if you didn't have your act together last year
in terms of keeping records and receipts for all this stuff, at least you can
get your house in order for when this year's tax return is due.
Hobby
vs. Business
The crucial distinction between a hobby and a business
is whether you engage in the activity with a profit motive. Now, by profit motive,
we don't mean that "gee, it's really great that I can make money doing something
I love", we mean "I'm doing this with the intention of making a profit
and if I can't make a profit doing this then I'll find something else to do that
will make me a profit". The difference is one of motive. In the former, the
motive for the activity was the doing - the enjoyment inherent in the activity
itself. Making money was an incidental, albeit most welcome, benefit. In the latter,
the motive for the activity was to make a profit. That's not to say that you can't
enjoy what you choose to do to make that profit, it's just that your primary objective
must be to make a profit such that if this venture is inherently unprofitable,
you would presumably choose not to pursue it. With a hobby, on the other hand,
even if the activity was inherently unprofitable, it is something you would choose
to do anyway.
OK, so much for your own subjective intentions. How does the
IRS decide whether you truly have a profit motive? There are two ways it goes
about it. The first is an objective test. Quite simply, the IRS will look at your
tax returns for the last 5 years and if you made a profit during at least 3 of
those years, you will satisfy the profit-motive test. If you don't meet this test
or if your business is new and you haven't filed 5 tax returns, then the IRS will
apply a subjective standard. In applying the subjective standard, the IRS auditor
considers and weighs several factors, including:
Businesslike Manner
of Carrying On Activity
The IRS will look at how you carry on your activity.
Do you keep a good set of books and records or do you chuck receipts into a battered
shoebox? Do you have separate bank accounts for your business? Do you invest in
advertising, marketing and promotion?
