Business or Hobby?

One question that arises every year at tax time among entrepreneurs and semi-entrepreneurs is how to know whether to classify what you do as a hobby or a business. The rules don’t always seem to be crystal clear. Oddly enough, as far as the IRS is concerned, if you made any money last year doing whatever it was that you were doing, they aren’t particularly concerned how you classify yourself. If you made a profit, any profit, they’ll be there expecting their share, period. If you only made $20, you have to report it on your tax return as income. They want the tax money.

The area in which they really grab their spectacles and begin taking a good, long look is if you lost money doing whatever it was that you were doing, especially if you were doing it from the cozy confines of your own home. This is where they will become real sticklers about the whole “business or hobby” classification. Let’s say you collect antique model cars. Last year you bought a few, sold a few, and traded a few. At the end of the year you totaled up the value of all of your transactions, and you noticed that you actually lost about $50. Unfortunately, you can’t just automatically write that off against any other income that you have. Unless you’ve got all of your I’s dotted and your T’s crossed about being a business, Uncle Sam is going to tell you that you can only write off that “hobby” loss against any gains that you may have made from the same hobby. In other words, they want the tax money.

So, how do you determine exactly what you have, a business or a hobby? Well, one basic, long-standing IRS rule states that if you’ve made a profit in three of the previous five years, including the current year, then for all intents and purposes you are a business. But if you haven’t been doing whatever it is that you’re doing for five years, you’re going to have find other avenues to prove to the government that you’re in it to make a living.

There are a number of ways to do this. One of the first ones might be to have a business license. This can go a long way in convincing everyone of your serious intentions about making a profit. It’s generally quite inexpensive to obtain one, and in most places, it’s the law anyway. Also, go to the local print shop and have some stationary, business cards and invoices made. Opening a separate bank account and keeping separate records are also good ways to show that you’re regularly spending time working in whatever it is that you’re working in.

Invest in your business. Buy books and magazines related to what you’re doing; attend seminars and subscribe to pertinent newsletters. All of this will show that you’re actively studying and learning your business with the serious intent of turning a profit. And don’t neglect to draw up a formal business plan showing your business’ projected future expenditures and earnings. If you’re truly serious about succeeding in your business, you should probably be doing these things anyway. They’ll put you on a heading for success.