If you’ve started a small business on the side, it’s important that the IRS sees it that way. Today on MoneyWise, we’ll help you understand the difference between a business and a hobby for tax purposes.
It’s tax season, and if you haven’t filed your return yet and you have a side business, you need to know whether you can deduct legitimate expenses.
BUSINESS OR A HOBBY?
First, the obvious. The IRS expects a business to make money. A hobby, on the other hand, is a not-for-profit activity. You can deduct expenses for business, but not for a hobby.
What’s the difference - in the eyes of the IRS? They provide a list of helpful questions to determine whether what you’re doing is actually a business:
<ul><li>Do you keep <a href="https://www.thebalancesmb.com/business-record-keeping-system-397850">records and</a> have a business checking account?</li><li>Do you need the income from this activity for your livelihood?</li><li>Are your <a href="https://www.thebalancesmb.com/business-losses-to-offset-income-397687">business losses </a>beyond your control or typical startup losses?</li><li>Is the business making a profit?</li></ul>Some types of activities related to your business will get extra scrutiny from the IRS, especially if they’re typically associated with hobbies, such as fishing or hunting, for example. That doesn’t mean you can’t deduct expenses, just understand that you might be more likely to get audited.
If it’s truly a for-profit business, you’re certainly entitled to claim typical and necessary <a href="https://www.thebalancesmb.com/deductible-business-expenses-3192959">business expenses</a> in full. And if you lose money, the loss can be used to offset other income on the owner's personal tax return.
If you’re really trying to make a profit, but haven’t been able to yet, you can choose to have the IRS delay in making a determination whether you’re engaged in a business or a hobby. Yup, there’s a form for that … IRS 5219.
Once you submit that form, the IRS will hold off on making a determination whether you have a business or a hobby, giving you two more years to turn a profit.
Now, besides turning a profit, you can do a few things to help your case, and these are just good business practices:
<ul><li>Establish a <a href="https://www.thebalancesmb.com/reasons-to-open-a-business-bank-account-393378">separate business checking account</a></li><li>Don’t mix your <a href="https://www.thebalancesmb.com/how-do-i-keep-personal-and-business-funds-separate-397491">business and personal expenses</a></li><li>Keep good business records</li><li>Register as an LLC or limited liability corporation … that might cost $200 or less</li><li>Get any necessary state or municipal licenses</li><li>Keep business hours or have a business website</li></ul>But keep in mind that the best way to get a favorable determination from the IRS is to turn a profit. If you fail year after year to do that, the business will likely be declared a hobby.
For the IRS to give a favorable ruling, in most cases, you must turn a profit in three of the last five years. But the IRS makes these determinations on a case by case basis, and certain factors can help your chances of being declared a business, even if the first few years are a struggle.
<ul><li>Are you operating in a business-like manner?</li><li>Do you market and promote the business?</li><li>Do you depend on the profits for your livelihood?</li></ul>Now, on your tax return, your adjusted gross income or AGI is the total of your wages, dividends, capital gains, and business income. If business income doesn’t exceed expenses for three of the last five years, it’s quite likely to trigger an audit. If the IRS determines that what you call a business is, in their eyes, a hobby, you won’t be able to take deductions from that income to offset other income when calculating AGI. To make matters worse, you still have to report — and be taxed — on any income you receive from the activity that’s now been labeled a hobby without being allowed to deduct expenses. Ouch. I guess the moral there is … don’t try to pawn your hobby off as a business.
So you might be thinking, “when am I in the clear?” The IRS says it tries to conduct audits as quickly as possible, but that’s not always the case. The statute of limitations prevents the IRS from assessing additional taxes after three years from the due date of the return or the date it was filed, whichever is later.
Just keep these things in mind that could trigger an audit: high expenses with little or no income; losses are used to offset other income on your return; and not showing profit in past years.
And if you’re operating a side business, the best advice we can offer is to hire a professional CPA! That will take all the guesswork out of it. On this program, Rob also answers listener questions: 
<ul><li>Should Christians be involved with cryptocurrency?</li><li>Where can you find your credit report regularly for free?</li><li>Should you keep a credit card open after paying it off, even if you don’t intend to use it, for purposes of protecting your credit score?</li><li>How can you give a large cash gift to family members while incurring the lowest possible tax burden?</li><li>What is the wisest way to transfer funds out of a 401k account from a previous employer? </li></ul>RESOURCES MENTIONED 
<ul><li><a href="http://annualcreditreport.com/">AnnualCreditReport.com</a></li><li><a href="https://www.ally.com/">Ally Bank</a></li><li><a href="https://www.capitalone.com/bank/checking-accounts/online-checking-account/">Capitol One 360 Checking</a></li><li><a href="https://www.marcus.com/us/en">Marcus</a> </li></ul>Remember, you can call in to ask your questions most days at (800) 525-7000 or email them to <a href="mailto:questions@moneywise.org">Questions@MoneyWise.org</a>. Also, visit our website at <a href="http://moneywise.org/">MoneyWise.org</a> where you can connect with a MoneyWise Coach, join the MoneyWise Community, and even download the free MoneyWise app. Like and Follow us on Facebook at MoneyWise Media for videos and the very latest discussion! Remember that it’s your prayerful and financial support that keeps MoneyWise on the air. Help us continue this outreach by clicking the <a href="https://moneywise.netviewshop.com/donate2">Donate tab on our website</a> or in our app.

FaithFi

Faith & Finance is a daily radio ministry hosted by Rob West. The program offers a practical, biblical and good-natured approach to managing your time, talents and resources.

Faith & Finance with Rob West

Maybe you have every intention of your business making a profit but, unless you meet certain criteria, Uncle Sam may view it as a hobby. Rob lets you know how to tell the difference.

Taxes: Business or Hobby?

FaithFi | Apr 2, 2022

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