You Can't Deduct that Loss

How to ensure your business is not deemed a hobby

You’ve loved dogs all your life so you decide to breed them and start a dog training business. Is this a business in the eyes of the IRS or a hobby? Knowing what the IRS is looking for and properly positioning your small business can save taxes and headaches if you are ever questioned by the IRS.

Why you should care
If your activity is a business, your income can be reduced by all your qualified business expenses even if it results in a loss. If your activity is deemed a hobby, no losses are allowed on your tax return, and even worse, after 2018 you cannot deduct expenses against this revenue. So you're telling me if I knit three sweaters and sell them for $1,000 I cannot deduct the cost of the wool if it is a hobby? Technically, yes! Which is why you need to change how you think about these kinds of activities.

Tips to make it a clear business
Here are some tips to ensure full deductibility of your expenses against your business income.

1. Profit motive. You must show that you intend to make a profit with your activity. The old rule of thumb was to show a profit at least three out of the past five consecutive years to safely qualify your activity as a small business. But this is no longer the case. Although more difficult to substantiate, you can show profit motive without ever showing a profit by your ongoing activities around the business.
2. Active participation. You need to be actively involved in your pursuit for success. If you simply invest money in the dog business, but are never there to care for them or give lessons, you will have a hard time justifying the business nature of the activity.
3. Be professional. Businesses have separate checkbooks, business cards and stationery. They have financial statements and show the same disciplines one would find in a “for profit” venture of the same type of activity you are pursuing. And they are organized as a business, ideally through a simple business structure like a single member LLC.
4. Pleasure factor management. If your business has a large enjoyment factor, you will need to be even more cautious about having proper records. If you claim to be a golf pro giving lessons, but then spend all your time playing golf, you will have a hard time justifying the activity as a true business.
5. Have multiple customers. If you only have one or two customers, who also happen to be relatives, your activity may be deemed a hobby. Having a number of customers, even without profits, can make all the difference in allowing for expense deductions.
6. Showing profit motive without profits - Part II. How else can you show profit motive when no profit is to be found? Advertising is one way to do this. Keep copies of all ads trying to drum up business. Keep a daily diary of business activities, noting who you meet and for what purpose. Create and keep sample product, even if it is not yet sold.
7. Understand your risk. There are certain business types that are under the IRS microscope when it comes to hobbies. Key among these are multi-level marketing businesses like Amway, Tupperware and Avon. It also includes the thousands of part-time sellers of goods on internet sites like e-bay. If you are in one of these business activities you will need to prove the business nature of your involvement and be prepared to be challenged.

Quick Checklist
Wondering if your business activity may be considered a hobby? Review this checklist. The more yes answers, the better your chances of defending your position.

• Conducted activity in business-like manner?
• Created a business entity?
• Have expertise in your activity?
• Put time and effort into the activity?
• History of income/profits?
• Have had prior success in a similar activity?
• Is there a low element of pleasure/recreation involved?
• Are there appreciating assets or an expectation that there will be?

Remember, having a business activity reclassified as a hobby can mean a big tax bite at tax time. But by keeping proper records and pro-actively knowing the pitfalls, you can avoid most problems.

"Tax Tips" are published to provide current tax information, tax-cutting suggestions, and tax reminders. If you would like more information on anything in "Tax Tips," or if you'd like to be on our mailing list to receive other tax information from time to time, please contact our office.
 
The tax information contained in this site is of a general nature and should not be acted upon in your specific situation without further details and/or professional assistance.
 
We are trusted CPA advisors servicing Burr Ridge, Hinsdale, Willowbrook, Darien, Naperville, and all Chicagoland area. 

Do you need assistance with your business and/or personal tax returns? Would you like to have a trusted source for your accounting, allowing you additional time to focus on increasing your business? Do you use QuickBooks, or plan to in the future, for your accounting? We include these in all our service packages, customized to fit your personal or business needs.  
 
We are currently accepting new clients. Your initial consultation is free, so you have nothing to lose and everything to gain. Our experienced staff is available to help you streamline your accounting, giving you more free time for yourself. Set up an appointment today by calling (630) 320-3720 or email us at info@monarchaccountinggroup.com. 
 
For more free resources, such as Tax Organizers, and Record Retention Schedules, access our website www.monarchaccountinggroup.com.

Mia Verc, CPA;  Janice Papais, CPA