It seems obvious, but in order to be able to deduct business expenses, set up a retirement plan, and claim tax breaks allowed to business owners, you must be engaged in a "trade or business." That is, you must be engaged in an activity that is carried on for a livelihood or for profit, even if you have some unprofitable years.
In order to claim any business expense deductions, you need to be operating a business—however profitable or unprofitable. In most cases, it is clear when someone is operating a business that seeks to make a profit, rather than dabbling in a pleasant diversion or hobby. But, this is not always true—especially not in the early years when few businesses turn a significant profit.
Does a "business" include those first few jobs or clients you take on in your spare time, to test the waters? Does it include accepting pay for some activity that you enjoy, such as giving golf lessons, assisting in catering or home improvement projects, or providing business advice? What about occasional sales of craft or artistic items? What about when you are trying your best, but your business is still losing money? In cases like these, are you meeting the "for profit" test?
Although the IRS is not limited in the kind of businesses that it can challenge as being hobbies, businesses that look like traditional hobbies (such as "gentleman farming" and craft businesses run from the home) generally face a greater chance of IRS scrutiny than other types of businesses.
According to the IRS, to constitute a trade or business, there must be some type of economic activity and there must be a profit motive (even though you may have actually experienced a loss for the year). "Profit motive" in this context means that you are aiming to achieve a real economic profit, not just tax savings. It is the profit motive that separates a business from a hobby, which is an activity engaged in purely for self-satisfaction.
If you aren't able to establish that you have a profit motive, your ability to deduct expenses will be severely limited by the hobby loss rules.
If your business is highly successful, generating more than enough income to support you and your family, your "profit motive" is highly unlikely to be questioned by the IRS.
But, what if you are just starting out and losing money—even if that's expected in your industry during the start-up period. How do you prove to the IRS that you mean business, and aren't just trying to deduct expenses of a hobby or personal living expenses?
There are two approaches:
An activity is presumed to be engaged in for profit and not as a hobby, if it is profitable in three out of five consecutive years. For a new business, this means that you don't have to show a profit for your first two years. (A narrow exception to this rule applies to horse breeding, training, showing, and racing. For these activities, a presumption of a for-profit activity arises if income exceeds deductions in two out of seven consecutive years.)
If your business qualifies for this presumption, it means that the IRS (not you) has the burden of proving that your business is a hobby, if the issue comes up in an audit. If you don't qualify for the presumption, you may still be able to show that you operated for profit under the IRS's nine criteria profit motive test.
Claiming the Presumption. While the "profit in three out of five years test," shifts the burden of proof if there is an audit, it's much better to avoid an audit in the first place! One way to reduce your chances for an audit, is to file Form 5213, Election to Postpone Determination as to Whether the Presumption Applies that an Activity Is Engaged in for Profit.
Form 5213 lets you officially elect to have the IRS wait until the first five years are up before examining the profitability of your business. Form 5213 should be filed within three years of the due date of the return for your first year in business. However, if you haven't filed the form and you are audited by the IRS, you can file the form within 60 days of receiving the IRS notice, as long as your three-year period has not expired.
Even if an activity is not profitable over a number of years, it can still be considered a business if the "nine-factor" test reveals evidence of a profit motive. However, if the activity is found to be a hobby, then the hobby loss rules apply.
The IRS evaluates nine critical factors to determine whether an activity is run for profit (even if losses have resulted), or as a hobby. It's important to realize that these factors are open to interpretation. Moreover, while a "yes" answer supports a finding of a profit motive, no one factor settles the matter.
How the business is run. Are you running the activity in a businesslike manner? Do you keep complete and accurate business records and books? Have you changed the way you operate the activity in order to increase profits or to become profitable?
Expertise. Do you have the necessary expertise to run the business? If not, do you seek (and follow) expert advice?
Time and effort. Do you spend the time and effort needed for the business to succeed? (Be forewarned, however. If the activity has significant personal or recreational aspects, simply spending a great deal of time on it, will not prove a profit motive.)
Asset appreciation. Is it likely that your business assets will appreciate in value over time? A profit motive can exist if gain from the eventual sale of assets, plus any other income, would result in an overall profit even if there's no profit from current operations.
Track record of success. Have you engaged in similar (or dissimilar) activities in the past and converted them from unprofitable to profitable enterprises?
History of income or loss. Did the business losses occur because the business was still in a start-up phase, or because of unforeseen circumstances? Many businesses that were started with high hopes in 2007 floundered in the 2008 economic downturn despite the owner's best efforts. However, if you continue the activity despite continuing losses for many years, it may indicate that the activity is a hobby.
Occasional profits. Are the amounts of occasional profits insignificant when compared to the size of your investment in the activity, and the amounts of losses suffered in other years? An occasional small profit for an activity generating large losses, or in which the owner has a large investment, will not establish a for-profit objective.
Owner's financial status. Is the business activity your only source of income? Few people base their continued economic survival on the happenstance of a hobby.
Personal pleasure or recreation. Is the business of a type that is not usually considered to have elements of personal pleasure or recreation?
The following two cases illustrate how these factors are applied. In one case, the required profit motive was found. In the other, the activity as a hobby.
Example. Ron was not able to establish that his drag racing activity was engaged in for profit.
He did not have a written business plan and did not maintain a general ledger, annual budget, expense forecasts or a separate bank account for his drag racing activity. He did not consult a business advisor about ways to make his drag racing activity profitable and all winnings from race events were used to maintain the cars and transporter. Although Ron saved receipts for his expenses, there was no evidence that he used those receipts as a management tool to reduce expenses or increase profitability and the individual offered no evidence of how comparable businesses operated. In addition, his drag racing activity allowed him to spend a significant amount of time with his children, which brought him personal pleasure. Based upon these factor, the Tax Court upheld the IRS's finding the drag racing was a hobby. As a result, his losses were not deductible.
Example. William's high-performance glider flight instruction and glider rides constituted a business.
He actively promoted his business through a web site to secure clients. Although his records weren't the best, the efforts he undertook to be financially successful tended to demonstrate a profit motive. In addition, he secured the appropriate licenses and training to meet requisite FAA requirements. Although the business was only part-time, he devoted all of his weekends to the glider activities. Although his business had losses during the first four years, these losses reflected the depreciation of the glider, the only asset of the business. William worked in the aviation field before and after he started the glider business, and his enjoyment of flying did not change the result of whether he was in the trade or business providing glider activities. Therefore, the Tax Court concluded that engaged in the glider activities with the primary purpose and intent of realizing an economic profit independent of tax savings for the years at issue.
How you go about showing that your activity is operated for profit will depend, in large part, on whether you expect it to profit over either the short run or long run.
Profit possible over short term. Try to maximize your income (and minimize deductions) in at least three years (the "profit" years), and maximize deductions (and minimize income) in the remaining two years (the "loss" years.) You can do this by planning when to receive income and when to purchase items that generate deductions. This may allow you to qualify for the presumption of profit motive. Bear in mind, that if your business continues to show a loss year after year and you don't abandon it, the IRS is likely to find you are motivated by something other than a profit motive.
Profit possible only over long term. If it appears that the business will not be profitable for some years, you won't be able to come within the presumption of profit motive. You'll have to rely on qualifying under the IRS's nine-point inquiry to establish profit motive.
No possibility of profit. Face it: what you have is a hobby. You can try to argue that you qualify under the IRS's nine-point inquiry, but in all likelihood you'll fail. If you want to continue this activity, you may as well either resign yourself to the limitation on hobby losses, or figure out a way to operate that generates profits.
What happens if your activity doesn't qualify as a trade or business? You are earning some money and you are also incurring some expenses. Are you required to report that income? And, can you deduct the expenses associated with earning it?
All Hobby Income Must Be Reported. A basic rule of tax law is that all income must be reported to the IRS. This is true even if you only earn occasional income from your hobby. Hobby income must be reported on Form 1040: you can not use the shorter forms, Form 1040A or Form 1040-EZ. All of your hobby income is reported as "other income" on Line 21 of your Form 1040, Individual Income Tax Return.
Hobby expenses are miscellaneous itemized deductions. You can only deduct expenses associated with the hobby as itemized expenses. Even worse, hobby expenses are considered "miscellaneous itemized deductions." This means that you can deduct only the amount that exceeds two percent of your adjusted gross income. (All you miscellaneous expenses are combined together and the total amount is subject to the two-percent floor.) This also means that these expenses are subject to the phase out of miscellaneous itemized deductions that will hit higher-income taxpayers starting in 2013.
Some expenses are deductible on your individual income tax return regardless of whether they are incurred in connection with a hobby. For example, real estate taxes, home mortgage interest, and casualty losses are deductible by virtue of being a home owner. Therefore, these amounts are not considered miscellaneous deduction and are not limited by the amount of your hobby income.
Hobby losses are limited to hobby income. If your activity is a hobby, rather than a business, your ability to deduct your expenses and carryover your losses will be limited. You can only offset hobby expenses against hobby income. Losses incurred by individuals, partnerships and S corporations in connection with a hobby are generally deductible only to the extent of the income produced by the hobby. In other words, you can't use a hobby to generate a tax loss that can be used to shelter your other income.