When your expenses exceed your revenues from your side business, the natural inclination may be to declare the loss on your tax return and offset it against income from other sources. However, the IRS may contest that this is not really a side business, but is instead, a hobby and thus would disallow the loss.

Why is this important? When your unincorporated for-profit business generates a tax loss, you can deduct the loss on form 1040, using schedule C to report a loss from a sole owned business, or schedule F for reporting losses from farming or ranching ventures. The loss is carried to page one of the 1040 tax form where it can offset income from other sources to help reduce your tax bill.

On the other hand, if your activity is deemed a non-for-profit hobby, you must report all the revenues on page one of the 1040 form. Your allowable expenses are limited to the amount of your revenue. This would unfortunately mean that you would never have a tax loss from a hobby, even if the losses were substantial. You must treat the amount of the expenses on your ‘hobby’ as a miscellaneous itemized deduction items on Schedule A.

Even when you do itemize, your write-off for miscellaneous deduction items is limited to those that are over 2% of your Adjusted Gross Income (AGI). If your AGI is high, your deductions for hobby expenses may be little or nothing. If you are subject to Alternative Minimum Tax, hobby expenses are completely disallowed. You suddenly could be a predicament of have a money losing side business that adds to your taxable income, but doesn’t add anything to your expenses.

That is why it is important to take a few necessary steps before the IRS calls your side business ‘a hobby’.

The tax law assumes that you have a for-profit business if the activity produces taxable income (revenues in excess of deduction) for at least 3 out of the most recent 5 years. Losses from the ‘lean’ years can be deducted because they are considered to be from a legitimate business. For horse racing, horse showing and breeding, you can assume to have a for-profit business if you can show positive income in 2 out of every 7 years.

So what happens if the number of years that you incur a loss exceeds the time period above? You may still be able to treat you activity as a for-profit business if you demonstrate that you have an honest intent to make a profit from it by:

– Keeping good records and conducting the activity in a business-like manner.

– Having expertise in the field, or hiring other people who do.

– Spending a substantial amount of time on the business to justify the idea that the business is indeed a business and not a hobby.

– Your losses have been caused by unusual events as opposed to foreseeable ongoing losses.

– Financial status – The IRS assumed that wealthy people can absorb ongoing losses, which indicates that what they have is a hobby, while ordinary people are usually trying to make a profit, indicating a business.

– What is the portion of your personal pleasure from the business? If you have a fishing boat, for example, you may derive more pleasure from it, especially if you operate it by yourself and use in only in the weekends. That is indicative of a hobby. But if your side business involves clearing septic tanks, even the IRS agrees it is not a pleasurable task, and so you can claim it as a business.

Do your homework and carefully plan to demonstrate that your business is real and not merely a disguised hobby.

Author Bio: Peter Holtz, CPA specializes in providing accounting and tax services to small business owners and professional practices in Stockton, CA. For more information, go here: http://www.financialperformancecenter.com

Category: Business Management
Keywords: CPA, accountant, business advisor