· Profits and losses from business activities are typically reported on Schedule C of Form 1040, but may also flow through to an individual’s tax return from S corporations or partnerships.
· True business losses are often deductible and may offset wages and income from other sources.
· Although businesses certainly may fail to generate profits, such losses receive scrutiny from the IRS.
· Expense deductions associated with hobby activities are severely limited.
· If an activity is a hobby instead of a business with a true profit motivation, the expense deductions will be limited to the amount of revenue earned.
· Although this may initially seem to result in a break-even scenario for business income or loss, taxpayers should understand that the deductions will be miscellaneous deductions that are subject to income-related limitations.
· Your hobby loss could actually generate taxable income on your tax return!
· If your business generates a profit in three of the previous five years, the activity will be presumed to be a for-profit activity.
· If the business does not generate a profit in three of the past five years this does not necessarily mean that the business will automatically be considered a hobby. However, it does place the burden of proof on the taxpayer to prove that the activity is being conducted with a profit motivation.
CHARACTERISTICS OF A PROFIT-ORIENTED BUSINESS
· True business activities typically require significant time and effort devoted to the enterprise.
· Profit-oriented businesses should be run in a business-like manner.
Utilize separate bank accounts for the business.
Invest time and effort with a true intent to make the business profitable.
Advertise and actively seek to expand the venture.
Draft and follow a business plan. Utilize budgets.
Derive revenues from a diverse customer base.
Consider incorporating the business or forming a limited liability company.
Consider the need to hire managers or other employees.
Seek the counsel of trusted advisors.
· Create a track record that demonstrates devotion to profit-centered activities.
· A reasonable expectation of asset appreciation may be a key factor.
· Other than the three-out-of-five-years rule, there is not one single factor that dictates hobby versus business. Taxpayers (and the IRS) must consider all factors in concert.
· Activities that would normally be recreational for most individuals may, in fact, be a legitimate business for certain individuals. However, such instances are rare.
· If you operate a true business that would normally appear to be a recreational activity you should devote extra effort to ensure that you operate the activity in a true business-like manner!