April 13, 2011

Is Your Business A Business Or A Hobby In the Eyes of The IRS?

Not long after I was married my husband’s accountant, who was responsible for filing our personal taxes, asked me point-blank if my business was real or not.   Having just dedicated what felt like my life and soul to getting the business up and running I just about hit the roof when he asked that.  How could it not be real?  I was working like a madwoman frantically – albeit unsuccessfully in Year 1 – to turn a profit.  But real, of course it was real!

 As the accountant calmly informed me, the Internal Revenue Service (IRS) has a different definition of what constitutes ‘real’ then you or I may have.   No matter how hard you work, there are certain hurdles the IRS wants to see small startup businesses crossing so that they can be confident this is a business you’ve started with the intention of making money and not simply a hobby.   Why all the fuss?  For Partnerships and LLCs any profits the business makes flows through to the shareholders so the shareholders report that money on their personal taxes and pay the IRS accordingly.  Along those same lines though, any losses the business experiences also flows through to the shareholders which can be used to offset income earned elsewhere.   Understandably the IRS doesn’t want you to create a “business” that has no intention of ever making money simply as a way to increase your deductions.  Hobbies – regardless of how much money you put into them – should be done on your own dime according to the IRS.

 The most straight-forward way to prove to the IRS that your business is in fact focused on making money is by showing that the business has been profitable in at least three of the last five years including the most current year.  Straight-forward yes, but not always easy to accomplish especially if you’ve just started a business and don’t have five years of tax returns.

 In this case the IRS will look at how you conduct your business and whether it’s done in a businesslike manner.  This may sound highly subjective but by doing things like registering your business, keeping up-to-date accounting records of all your transactions, and by keeping separate bank accounts for the business you will go a long way in proving to the IRS that you are running the business with the goal of turning a profit.  You should also show measurable improvement year-over-year to show the IRS that you are working to get your business towards profitability even if that doesn’t happen in the first several years.  Showing a decrease in losses every year will illustrate that you are working towards profitability and help keep your tax return from drawing unwarranted suspicion.   

More information about the IRS definition of business vs. hobby can be found here but, as always, if you have questions about taxes you should consult a certified accountant.