After reading my series of articles on how to save money on your taxes, a buddy of mine decided that he was going to start taking extra tax deductions by turning one of his hobbies into a business.
Hey Steve! You know how I love to paint right? And just the other day I sold a painting to someone on Ebay… Why don’t I just call this a business and declare business losses off my tax return? May as well right?
At first glance, my friend’s logic sounds reasonable. After all, he does create paintings that are sold for profit as a side business. So shouldn’t he be able to take business deductions and losses for all expenses incurred while painting?
Unfortunately, the answer to this question is a bit complicated. While my friend is technically allowed to deduct business related expenses for his painting business, the extent of these deductions depends on whether the IRS considers his business a legit business or not.
If my friend were to ever get audited and the IRS ruled that his business was not a true business, then he would not be able to deduct any business losses on his tax return.
Instead, he would only be allowed to deduct expenses up to the amount of income that his hobby has generated and nothing more.
Obviously, these rules are in place so people don’t abuse the tax system. If you declare business losses on your tax return year after year, you can face stiff penalties and fines if the IRS determines that you are just spending money on just a hobby.
The tax benefits of running a business only exist if you are actually trying to turn a profit.
What Does The IRS Consider A Business Vs A Hobby?
The business vs hobby rule is somewhat of a gray area when it comes to the IRS. According to the tax code, a business must actively be “engaged in trying to make a profit” in order to be considered a business.
So how do you demonstrate your profit intentions to the IRS in the event of an audit?
Be Profitable 3 Out Of 5 Years
The easiest way to show your profit motive is to actually turn a profit. If you are profitable, then no one can dispute whether you are actually trying to make money because you really are.
In general, your business is safe from being considered just a hobby if you turn a profit for at least 3 out of every 5 years of operation. The profit amount doesn’t have to be large, even a couple of bucks profit is good enough for the IRS.
That is why in general, it’s okay to declare business losses on your tax return for up to 2 years without increasing your risk of an audit.
However, if you declare business losses on your tax return for longer than 2 consecutive years, the chances of an audit increase dramatically.
What If I Fail The 3 Out Of 5 Test?
Just because you aren’t turning a profit for 3 out of the 5 years doesn’t necessarily mean the IRS is going to declare your business a hobby.
It just means that you are more likely to be audited. If you find that your business is not profitable for over 2 consecutive years, you basically have 4 choices.
- You can close up shop. This option makes sense if you don’t think that you’re ever going to be profitable. Sometimes, it makes sense to cut your losses on a dead end idea.
- You can continue declaring losses on your tax return and risk getting audited. This option is a good choice if you are confident that you can convince the IRS that your business is for real
- You can start a new venture altogether and declare losses on behalf of the new business. Of course, this can come across as a bit sketchy to the IRS especially if you happen to start a new business every two years.
- You can stop declaring losses on your tax return. Usually if you stop cold turkey and lie low for a while, you can stay below the radar of an audit
My Business Is Real And I Want To Risk It
Like I mentioned in the previous section, just because you aren’t turning a profit doesn’t mean you aren’t running a real business in the eyes of the IRS.
Some business ideas just take a little longer to materialize gains. If you have confidence in your business plan, then there’s no reason to fear the IRS.
Just in case of an audit though, you should do the following things to make sure your case for being a real business is air tight.
- Keep Good Records – Track each expense with as much detail as possible. If you are spending money on dining or entertainment, make sure you jot down who you are entertaining, why you are wining and dining them and the precise date and cost. Keep your business accounts completely separate from your personal ones and maintain an accurate spreadsheet of all expenditures.
- Keep Your Advertising Collateral – Most real businesses advertise in some shape or form. Make sure you keep copies of all of your advertising collateral so you can show it to the IRS. This includes business cards, flyers, newspaper ads etc…
- Keep A Business Calendar – By marking down important dates and milestones for your business on a calendar or scheduler, this shows the IRS that your business is happily progressing on a path towards profitability.
- Run A Legit Business – Make sure you register for all the necessary permits to run your business legitimately. If you do everything strictly by the book, you are showing the IRS that you are putting forth your best efforts in maintaining a real business.
Don’t Take Losses For The Hell Of It
Believe it or not, it’s pretty easy for the IRS or any third party to tell if you are just pretending to run a real business. So don’t start declaring losses on your tax return for the sake of saving money on taxes. The IRS will find out eventually.
Even if you are sandbagging it and taking deductions on just a hobby, the amount of work required to fake being a real business is simply not worth it.
If you are taking business deductions, then be a real business with real profit intentions. Getting caught with an audit is not worth the time or the money.
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