Jeff Neuburger

Are you running a business or enjoying a hobby?

This is the kind of question that is likely to greatly annoy you as you struggle with the toil and expenses of keeping your small business going. While you may vehemently defend your hard work as a start-up business, there’s more to it.  In fact, it’s a question that the Internal Revenue Service may very well ask when you claim a deduction for business losses. If the deductions pertain to a claimed business activity that is deemed by the IRS to be a hobby, then such deductions can’t be used to offset other income.

Deductions for business expenses

The Internal Revenue Code Section 162 allows taxpayers to deduct the “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” The IRS reportedly is cracking down on taxpayers who claim business expenses, when they are actually related to a hobby from which the taxpayer doesn’t expect to reap a profit. In an IRS fact sheet issued in April 2007, the agency claims that improper deduction of hobby expenses is costing the federal government $30 billion a year in unpaid taxes.

Business versus hobby

The IRS fact sheet outlines the following important points:

• The IRS considers an activity a business if it is “carried on with the reasonable expectation of earning a profit.”
• The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five years, including the current year (there is a special rule for breeding, showing, training or racing horses).

The IRS also lists a series of factors that taxpayers “should consider” in addition to the factors noted above, in determining whether an activity is a business or a hobby:

• Does the time and effort put into the activity indicate an intention to make a profit?
• Does the taxpayer depend on income from the activity?
• If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
• Has the taxpayer changed methods of operation to improve profitability?
• Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
• Has the taxpayer made a profit in similar activities in the past?
• Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?

Keeping good records, getting advice

One factor that the IRS doesn’t include in the fact sheet, but it is a fundamental best practice in running a business, is the maintenance of good records. If your business status is challenged, good business recordkeeping can help you show the IRS that your activity is a serious business intended to make a profit, one of the key factors in the business versus hobby determination. 

Setting up and maintaining good business records may mean engaging the services of an experienced tax attorney or business accountant at the startup point, especially if you are a new business owner. If you decide to go it alone, the IRS has a publication for that too. IRS Publication 583 – “Starting a Business and Keeping Records.”
 
The posts on this blog reflect the personal views of Jeffrey D. Neuburger, in his individual capacity, and do not necessarily represent the views of his law firm or his clients, and are not sponsored or endorsed by them. The information contained in this blog is provided only as general information for educational purposes, and no warranty or representation is made about the accuracy of the information provided. Blog topics may or may not be updated subsequent to their initial posting. This information is not provided in the course of an attorney-client relationship and is not intended to constitute legal advice. This blog should not be used as a substitute for competent legal advice from a licensed attorney in your state.

Posted by Jeff Neuburger on June 21, 2007 | Comments (0)