Many new businesses begin operations on weekends and evenings so the proprietor can supplement income earned elsewhere until the new business starts making a good profit. These side businesses are often based on an activity or pastime that the business owner finds enjoyable and is particularly skilled at. It’s also not rare for them to run at a loss, at least during the initial establishment phase of the business life cycle.

Now, you may believe that the silver lining to these business losses is that you can offset them against your other employment income in your tax return. However, the IRS has stringent requirements on what is classified as a business and what is classified as a hobby; and, unfortunately, losses from ‘hobbies’ are not claimable.

Therefore, you need to look into how the IRS classifies a business as opposed to a hobby because not only are there different reporting requirements in your tax return, but losses from ‘hobbies’ cannot be used to offset income from other sources. Expenditure incurred in relation to the revenues from a hobby may be claimed, but the deduction is capped at the amount of the revenue which results in a net effect of zero.

If you, following the IRS requirements, record these expenses as miscellaneous itemized deductions on Schedule A, those deductions are limited to only those that are over 2% of your Adjusted Gross Income which could mean that you’re entitled to claim little to nothing of these expenses.

And there is further bad news for those who are subject to Alternative Minimum Tax under which expenses incurred in connection with a ‘hobby’ are disallowed entirely. In this case, you stand to be penalized severely because you miss out on claiming the loss against your other income, and are also required to declare and pay tax on the revenues from the hobby.

There are many businesses that sometimes make losses, especially in the first few years. If you’re operating a genuine business and truly intend and foresee it becoming profitable in the future, there are steps you can take to demonstrate the legitimacy of your business thereby increasing the likelihood of the IRS allowing your claim for business losses.

Firstly, the IRS recognizes that sometimes the market is unfavorable and financial crisis can strike anyone, anytime; and will not reclassify your business as a hobby provided it has produced taxable income (i.e., revenues exceed expenses) for at least three out of the most recent five years. For businesses related to horse racing/showing/breeding, the timeframe is more generous requiring taxable income in at least two out of the most recent seven years.

However, no matter how well-intentioned or hard-working a business owner may be, sometimes this requirement is not able to be met. If you find yourself in a situation whereby your business does not make taxable income in the minimum number of years over the period, you may still be entitled to claim those losses against other income if you can demonstrate an honest, genuine intention to earn a profit.

Actions that you take today will be assessed subjectively by the IRS to help determine whether your loss is a result of a ‘business’ or a ‘hobby’ and these include:

– Accurate and detailed record-keeping.

– Conducting business operations in a business-like manner.

– Technical knowledge, expertise, or experience in the field or industry, or the employment of such persons.

– Undertaking business activities and support activities for a substantial amount of time each day/week in similar proportion to other comparable businesses which are profitable, and not a hobby.

– Evidence that the contributing factors to losses are unusual or uncontrollable events, as opposed to foreseeable and manageable issues.

– Financial status – The fact that wealthy people are capable of absorbing ongoing losses might add weight to the argument that the loss-making activity is a hobby. People who require an income from their business to support and provide for their family would typically not continue a loss-making hobby with no potential for profit generation in the short term.

– The IRS may also consider the amount of personal pleasure derived from the activity. For example, a fishing boat that you operate on your own at weekends is indicative (but, on its own, not definitive) of a hobby, while activities involving waste collection, unhygienic, or dirty tasks is suggestive of ‘work’ rather than ‘play’.

The bottom line is that the IRS appreciates that a business-a genuine business-may make losses some years. However, there are safeguards to prevent any old home hobbyist from claiming back the costs of their leisurely pursuits from the tax man. This means that you need to make sure that your genuine business does not inadvertently fall foul of the rules by proactively doing all that’s required to prove that you have a realistic for-profit intention and prospect of success.

Roy Fisher, CPA specializes in providing accounting and tax services to small business owners and professional practices in Houston, TX. For more information, go here: http://www.ledger-solutions.com

Roy Fisher, CPA specializes in providing accounting and tax services to small business owners and professional practices in Houston, TX. For more information, go here: http://www.ledger-solutions.com

Author Bio: Roy Fisher, CPA specializes in providing accounting and tax services to small business owners and professional practices in Houston, TX. For more information, go here: http://www.ledger-solutions.com

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