Any business can suffer a temporary downturn, but before you go ahead and automatically claim an annual business loss on your tax return, take a moment to consider whether you may inadvertently fall foul of the hobby/business rules because, if the IRS deems that your ‘business’ is actually a ‘hobby’, your deductions will be denied.

In an effort to prevent taxpayers from offsetting the costs of participating in hobbies against genuine business revenue, the IRS requires that for at least three out of the preceding five years, your activity has earned a net profit. However, if your endeavor relates to horse racing, breeding, or showing, this test is relaxed to at least two out of seven years.

If the IRS does indeed deem your endeavor to be a hobby, the loss you had reported on Schedule C of Form 1040 is disallowed and instead you are required to report revenues on page one of form 1040. Deductions related to this activity are declared on Schedule A, can only be deducted to the extent they exceed two percent of your adjusted gross income, and cannot exceed the revenue earned from the activity. Therefore, no tax loss is possible on a ‘hobby’, even if the monetary loss is substantial.

Another potential trap applies to those who are subject to Alternative Minimum Tax. Under this system, expenses from hobbies are disallowed entirely, yet the revenues are still required to be reported as taxable income. You could find yourself in a situation where your money-hemorrhaging hobby is increasing the amount of tax you pay!

So, what should you do if you are operating a genuine business but have not met the three-year net profit requirement? Fortunately, the IRS recognizes that sometimes, even if the business is genuine and intended to be run at a profit, things don’t pan out that way. If you can prove that you are engaged in a ‘for profit’ business activity, the IRS should allow you to claim the business loss.

There is no definitive test for whether the IRS believes you have an honest intention of running a for profit business, but it takes the following factors into account when determining – on a case by case basis – whether you are running a business or a hobby:

– The amount of effort you put into the endeavor. This could include number of hours spent working;

– Whether you depend financially on the revenues from the activity. Wealthy individuals are able to absorb losses for a prolonged period of time while enjoying a hobby;

– The reason for the losses. Start-up business often don’t run at a profit immediately, but if the forecast is for continued losses well into the future, that could be an indication that you are not operating a for profit venture;

– Whether you’ve taken a proactive approach to improving profitability;

– Do you have the necessary skills or expertise to carry on the business successfully?

– Whether profit was made in other years;

The expectation of profit in future years from the appreciation of assets used within the activity;

– The level and method of record-keeping, and whether the activity is conducted in a business-like manner;

– How much personal pleasure is derived from the activity? For example, a fishing operation run by a person who merely goes out by themselves each weekend is indicative of a hobby, but a person spending eight hours a day cleaning toilets or emptying septic tanks does not seem to be doing something very pleasurable, and the IRS would likely deem that you do have a ‘for profit’ intention.

If your business is struggling to make a profit, make sure you prepare carefully and are ready and able to demonstrate to the IRS that you are operating a ‘for profit’ business, and not just spending time and money on a ‘hobby’.

John Hemmendinger, CPA specializes in providing accounting and tax services to small business owners and professional practices in Cedar Knolls, NJ. For more information, go here: http://www.hemmendinger.com

John Hemmendinger, CPA specializes in providing accounting and tax services to small business owners and professional practices in Cedar Knolls, NJ. For more information, go here: http://www.hemmendinger.com

Author Bio: John Hemmendinger, CPA specializes in providing accounting and tax services to small business owners and professional practices in Cedar Knolls, NJ. For more information, go here: http://www.hemmendinger.com

Category: Advice
Keywords: CPA advice, business advice, CPA services