#1 – BUSINESS LOSSES
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 occasionally fail to generate profits, such losses receive scrutiny from the IRS.
#2 – HOBBY LOSSES
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.
Thus, your hobby loss could actually generate taxable income on your tax return!
#3 – PRESUMPTIVE RULE
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's shoulders to prove that the activity is being conducted with a profit motivation.
#4 – 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.
Advertise and actively seek to expand the venture.
Draft and follow a business plan. Utilize budgets.
Derive revenues from a diverse customer base.
Incorporating the entity may be advisable.
Consider the need to hire managers or other employees.
Successful businesses often 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.
#5 – PERSONAL ENJOYMENT
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 consider it doubly important to ensure that you operate the activity in a true business-like manner!