Business or Hobby?

Are you living the dream?  Do you have a business that you are passionate about and that you cannot wait to get back to everyday?  You may think it is a business, but the IRS may think that it is your hobby.

What is the difference?

The main difference is that you are entitled to deduct all the ordinary and necessary expenses associated with operating a business.  However, your hobby related expenses may not be deductible, and to the extent they are the deduction is limited.

There are 9 factors used to determine if the taxpayer is engaged in a business or a hobby.

1. Whether the activity was conducted in a business-like manner.  Basically, did you have a business plan and keep financial records?  Did you keep a separate bank account for the activity?  Are you doing the types of things that a prudent business person would do?
2. The taxpayer's expertise or that of his advisors.  You need to have sufficient expertise to show that you know how to make that activity profitable.
3. The time and effort expended.  Essentially, is this activity something that you do during your free time, or are you devoted to it full-time?
4. The taxpayer's expectation that assets used in the activity may appreciate in value.  If your hobby involves the accumulation of assets, like coin collecting, you must show that you purchased the assets with the intention of eventually selling them for a profit.  A coin collector who knows that the coins will go up in value but has no intention of ever selling his coins is involved in a hobby, not a business.
5. The taxpayer's success in similar or dissimilar activities.  If you have been very successful in related ventures, then even if this activity is losing money it is likely a business.  On the other hand, if all your similar activities have lost money it is more difficult to prove that you are engaged in the activity with the hope of making money.
6. The taxpayer's history of income or loss.  This is similar to the prior factor, except that it looks only at this one activity.  If you made consistent income in the past it is more likely to be considered a business than if you had only sporatic income or consistent losses.
7. The amount of occasional profits.  The more income you earn from the activity, the more likely it is that it will be considered a business.
8. The taxpayer's financial status.  If most of your income is derived from other sources, then this activity will look like a hobby.  On the other hand, if most of your income comes from this activity it looks like a business.
9. The personal pleasure the taxpayer derives from the activity. This is a subjective factor.  You can love your job (and I would hope that you do), but if it looks like that is a greater motivation for you than money it will likely be deemed a hobby.

Outside of these factors, there is a safe harbor available to taxpayers.  If the activity has been profitable for 3 out of the last 5 tax years, including the current year, then the IRS will presume that the activity is carried on for profit (i.e., that it is a business).  If you breed, show, train, or race horses, you only have to be profitable for 2 out of the past 7 years in order to qualify for this safe harbor.

If you need help determining whether you are engaged in a business or a hobby, or if you have any other questions related to this please do not hesitate to send me an e-mail.

As always, I appreciate any feedback you have.  Please leave it in the comments section below.