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.
Get My Free Mini Course On How To Start A Successful Ecommerce Store
If you are interested in starting an ecommerce business, I put together a comprehensive package of resources that will help you launch your own online store from complete scratch. Be sure to grab it before you leave!
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.
Ready To Get Serious About Starting An Online Business?
If you are really considering starting your own online business, then you have to check out my free mini course on How To Create A Niche Online Store In 5 Easy Steps.
In this 6 day mini course, I reveal the steps that my wife and I took to earn 100 thousand dollars in the span of just a year. Best of all, it's free and you'll receive weekly ecommerce tips and strategies!
Related Posts In Legal And Taxes
- How To Open A Business In The USA As A Foreigner From Another Country
- Types Of Businesses – C Corp Vs S Corp Vs LLC Vs Sole Prop
- 11 Best Online Bookkeeping Services For Small Businesses
- Business Expenses: How To Take Tax Deductions On Your Car, Home, Travel, Meals & Equipment
- How Much The Average American Can Save On Taxes By Having A Business
Steve Chou is a highly recognized influencer in the ecommerce space and has taught thousands of students how to effectively sell physical products online over at ProfitableOnlineStore.com.
His blog, MyWifeQuitHerJob.com, has been featured in Forbes, Inc, The New York Times, Entrepreneur and MSNBC.
He's also a contributing author for BigCommerce, Klaviyo, ManyChat, Printful, Privy, CXL, Ecommerce Fuel, GlockApps, Privy, Social Media Examiner, Web Designer Depot, Sumo and other leading business publications.
In addition, he runs a popular ecommerce podcast, My Wife Quit Her Job, which is a top 25 marketing show on all of Apple Podcasts.
To stay up to date with all of the latest ecommerce trends, Steve runs a 7 figure ecommerce store, BumblebeeLinens.com, with his wife and puts on an annual ecommerce conference called The Sellers Summit.
Steve carries both a bachelors and a masters degree in electrical engineering from Stanford University. Despite majoring in electrical engineering, he spent a good portion of his graduate education studying entrepreneurship and the mechanics of running small businesses.
Great post. Another important thing to do is to get a good tax person. It took me forever to find a good one, but it was definitely worth it.
How are “Death & Taxes” the supposedly two inevitable things yet you have to go through years of schooling to figure taxes out? Take your taxes to 3 accountants and they will each spit out a different number. Thanks for another great post!
Great advice! Keeping good recorders is so important. Especially if you are going into a business where there is a lot of competition. The chances of not turning a profit are extremely high in the first 3 years.
My question Steve is how do you know when to let go and close up shop. I understand that it takes time. You even wrote about it saying that a lot of business go through that slow phase, but how long do you think it should take for things to get up and running?
Great site. Thank you so much for article, it provided so much information.
Quick question, Steve.. If you claim income on a hobby, do you know what percentage the IRS takes?
There is even let’s say “hope” if you fail the 3 out of 5 test. These are the questions IRS employees will ask:
1. First, the IRS will try to determine whether the activity is carried out in a businesslike manner. Apart from looking at how records are kept and advertising, they analyze whether the taxpayer tries to hold down costs as much as possible. Additionally, is there a business plan or an outline of when the taxpayer reasonably expects to make a profit? Is there a separate business bank account?
2. Does the time and effort put into the activity indicate the intention to make a profit? The IRS will try to determine whether the taxpayer depends on the income from the activity.
3. If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the startup phase of the business? The IRS recognizes that many businesses do not expect to make a profit early in their life cycle, but they will want to see if the taxpayer has changed any methods of operation to improve profitability.
4. The IRS will look at the taxpayer’s past. Has he or she made a profit from similar activities in the past? Does he or she have prior business experience? Does the taxpayer have the knowledge needed to carry on the activity as a successful business?
5. The IRS will look at whether the activity has made a profit in past years and whether there is a reasonable expectation of future profit from the appreciation of assets used in the activity.
Source: http://www.prestinaegele.com/business-or-hobby-it-matters-to-the-irs
Hope it helps! 🙂
Thanks for sharing this nice information here. it’s really informative for me.