Date: February 17, 2023
Do You Know if Your Business is Considered a Hobby by the IRS?
Exciting news– you’ve started a business, or maybe even a second business! Most Entrepreneurs just starting out know that their business won’t be profitable right away. But what factors does the IRS consider when deciding to reclass your business as a hobby? It’s important to know because a hobby is not able to deduct business expenses. Read below to learn more about the 9 factors the IRS asks the taxpayer to make their determination on whether you have a business or a hobby: (1)
1. Do you keep accurate books and records and generally operate as a business?
2. Do you depend on this income for your livelihood?
3. Do you invest time and effort into making this venture profitable?
4. Are your business losses due to circumstances beyond your control (or normal for the start-up period of your business type)?
5. Do you change up your operation methods as needed to become more profitable?
6. Do you have expert advisors and the knowledge to run the business?
7. Have you had profitable successes with similar businesses in the past?
8. Do you make a profit, and if so, how much?
9. Do you expect to make a profit on the assets in the future? (2)
What entity structures may be affected by this? If you operate as a Sole Proprietor, Limited Liability Company (LLC), Partnership, or S Corporation, then you are subject to this. Keep in mind that the IRS is looking for the business to have had a profit in at least three of the last five years. Good news though- if you are concerned and want to postpone the IRS from making a determination, you may use Form 5213. This allows you more time (three years) to make a profit essentially. You will want to make this election within three years after the due date of your first tax year return for the business. (3)
It’s imperative to carry out generally accepting accounting principles (GAAP) – for example, having a business checking SEPARATE from your personal checking and no co-mingling personal and business transactions. By hiring a professional to handle your books, you not only ensure your bookkeeping is timely and accurate, but you’ll have clear visibility into your profitability. Having a Tax Strategist on your side will help you make sure you are you are in compliance with federal and state tax laws (a HUGE and necessary help). They will also offer you guidance on how to avoid key audit triggers such as low income but high expenses, past years not showing a profit, etc. Remember – if the IRS determines that you have a hobby instead of a business, you cannot deduct any business expenses – turning that into one expensive hobby! No business deductions mean you pay tax on total income! Make sure you are doing your due diligence and hire an expert to guide you and ensure the proper steps are in place.
We love helping our clients crush their financial goals, all while ensuring that best accounting practices are followed. Expert guidance is a key component to your success, growth, and profits. If you are looking for someone to be in your corner to help guide you, we are happy to help! Click here today to speak with one of our tax strategists.
(1) How the IRS Decides If Your Hobby Is a Real Business (thebalancemoney.com)
(2) Earning side income: Is it a hobby or a business? | Internal Revenue Service (irs.gov)
(3) Publication 535 (2022), Business Expenses | Internal Revenue Service (irs.gov)