Business versus hobby? Why does that matter? Because there is a tax impact, that’s why.
Are you tired of the rat race? Are you ready to make the American dream a reality? Congratulations, you live in Massachusetts, one of the easiest places in the world to start a business . . . except when that business is not really a business but a hobby.
The First Five Years of a Business
Many businesses tend to lose money the first couple of years of operation. It usually takes five years to make a profit. Because they are a business they get to write off all of their losses. Here is where a business versus hobby will pan out. If you have a hobby, you can only use the losses to offset any incidental hobby income. The tax benefits of having a business has led many a taxpayer to run afoul of the IRS. While there is no single hard and fast rule that one can use to determine if you have a hobby or a business, the IRS has a list of criteria that one can use to make that determination.
- The manner in which the taxpayer carries on the activity. Do they complete accurate books? Were records used to improve performance?
- The expertise of the taxpayer or his advisers. Did the taxpayer study the activities business practices? Did they consult with experts?
- The time and effort expended by the taxpayer in carrying on the activity. Do they devote much of their personal time and effort?
- The expectation that the assets used in the activity may appreciate in value. Is the plan to generate profits through asset appreciation?
- The success of the taxpayer in carrying on similar or dissimilar activities. Have they converting them from unprofitable to profitable?
- The taxpayers history of income or losses with respect to the activity. Has the taxpayer become profitable in a reasonable amount of time?
- The amount of occasional profits. Even a single year of profits can be a strong indication that an activity is not a hobby.
- The financial status of the taxpayer. Does the taxpayer have other income sources that are being offset by the losses of the activity?
- Does the activity lack elements of personal pleasure or recreation? If the activity has large personal elements it is indicative of a hobby.
A Likely Hobby
Let’s say that you are an electrician and you put together remote controlled robots on the side. You periodically make sales of your creations online and at a robotics club. You do not really keep financial records. You don’t have a written business plan. I would probably say that this is a hobby, even if it makes an occasional profit as it does not meet any of the business criteria presented by the IRS.
A Likely Business
Now let’s say you decide you want to turn this same activity into a business. You consult with your tax advisor and a lawyer. You put together a business plan; you set up an LLC, a website, a separate bank account. You feature a lineup of products that you intend to make a profit on. You keep excellent books and you pour a ton of sweat equity into the venture. Despite your best efforts, your robots are a complete disaster and you lose your shirt. You then make the decision to close up your business. In this instance, despite having lost money, I would probably classify this as a business as it meets virtually every IRS business criteria. In the end, you end up with the two consolation prizes. The first is that you get a nice tax break when you write off all your business losses; the second is that this is a great country for closing out a business as well.
Business versus Hobby, Sort it Out
Alex Franch, BS EA can help you work through all the criteria of a business versus hobby. Call him at 781.849.7200 to determine if you will get any tax benefit from your business investment. We invite you to leave your comments below or on our Facebook or Google + pages. If you found this information helpful , and you think someone else might benefit from it, feel free to share it on your social media pages.