Does The IRS Care Whether My Business Shows A Profit?
Do you dream of leaving your day job to pursue your passion? Do you want to turn your hobby into a career? Maybe you aren’t there yet, but you’re working on it. What are the tax issues you need to consider when your passion, your hobby, is not yet your career?
Perhaps most important is the decision to incorporate your business or not. Doing so can make all the difference when it comes to which rules apply. By incorporating, you’re taking steps to formalize the activity and will be subject to the rules that apply to “real” businesses like IBM and Microsoft. However, if you decide not to incorporate, you’ll particularly want to be aware of the Hobby Loss Rule and how it impacts your ability to deduct business expenses.
The Hobby Loss Rule applies to unincorporated businesses that show a loss and is used by the IRS to determine whether or not any expenses are deductible. If the activity does not produce a profit in at least 3 of the prior 5 years, the IRS presumes it’s a hobby and all deductions are disallowed!
The Hobby Loss Rule doesn’t apply to incorporated businesses engaged in for profit. In fact, you’re probably already aware that many large businesses rarely, if ever, show a tax profit. But their expenses are not disallowed.
The rules for deducting business expenses (like office supplies, rental space, telephone service) are that the expenses must be reasonable and necessary to the trade or business for which they are incurred. And most importantly, that trade or business must be engaged in for profit. The determination of what is “engaged in for profit” is a facts and circumstances determination. While not totally inclusive, the IRS looks at the following facts:
- Is the business incorporated.
- Whether or not the time and effort you put into the activity is indicative of an intention to make a profit.
- If you depend on income from the activity.
- If you have losses, are they caused by something beyond your control or are they part of start-up costs?
- Whether you’re working to change operation methods to make a profit.
- Your ability to operate the activity as a successful business.
- If you’ve been profitable in similar activities in the past.
- Whether your activity has made a profit in some years.
- If you expect to make a profit in the future from the appreciation of assets used in the activity.
If you’ve incorporated your business, it’s much easier to satisfy these criteria. But if you haven’t, then the Hobby Loss Rule applies and you need to consistently show a profit or run the risk of having expenses disallowed.
If you have an activity that you consider to be a business but need advice to assess your tax options and how to best proceed, then schedule your free consultation by calling (480) 888-7111 or submit a web request here.
By: Evan A. Nielsen