If it makes money, it’s taxable, right? This is a general thing that makes sense to most people. If the Internal Revenue Service classifies your business as a hobby, this saying still applies to you; however, it has some potential downsides.
The Internal Revenue Service has many rules, regulations, and tests to see if a business owner qualifies to claim deductions related to the business they’re operating. One of the commonly confused classifications is the hobby. Though it’s simple, many taxpayers are trying to get their heads around the concept of what makes a business hobby.
The IRS test for hobby vs. business
The Internal Revenue Service has a simple three-year test to see if your business is legitimate or a hobby. If your business declares loss for at least three years out of a five-year period, there is a good chance that the agency will classify it as a hobby. At first glance, this doesn’t seem so bad as you won’t have any profit to be taxed, but you get to claim no deductions for the so-called business.
Whatever the costs may qualify, what you get in return for your expenses isn’t available at this point once the IRS classifies it as a hobby. This is because the IRS won’t allow you to claim a deduction for your hobby. If it’s the other way around where even if you make a few bucks, the profit is taxable regardless of the amount. In this case, the IRS may not treat your business as a hobby as you fall outside of the three-year test period.
Business status is classified as a hobby
If you’re wondering how those big corporations still lose money over and over but don’t lose their business status, know that this outcome usually happens with small businesses and, rather micro businesses. When you start a business, the Internal Revenue Service assumes you intend to make a profit. In the case that it doesn’t happen for three or more years over five years, it’s still likely to get back your business status.
You can still retain your business status if you intend to make money but lose despite your efforts. As long as there is an effort and time invested into the business for making a profit, it’s a real business – it can’t be a hobby.
Things to look at in your business
Here are additional requirements that the IRS can change your business status to a hobby if not met.
Depending on income: Like any other business owner, depending on the income your business generates is a strong indication that you intend to make money. Otherwise, you won’t be able to make a living; therefore, it’s a real business. If you don’t depend on the income and the business keeps losing money, there isn’t a strong reason for the Internal Revenue Service to keep your business status.
Authority over losses: Are the losses something you can do about it? If not, there is a reason why you keep losing money but can’t do anything about it due to conditions that are beyond your control. This is a great indicator that the IRS can look at and say that you’re trying, but despite the best efforts, the business keeps losing money due to things other than internal wrongdoings.
Prior experience: One would assume that it’s hard for someone who’s working in tech for all their lives to transition into becoming a farmer. You may love doing what you do, but the above example is a good one to show you why the IRS thinks your business is a hobby. If you don’t have the required knowledge in your business field, it’s a strong sign that you’re pursuing enjoyment rather than for a profit motive.
Time and effort invested: Money isn’t the only thing the business owners invest into their company. With a lack of time and effort ingrained, the IRS likely sees it as a hobby rather than an actual business. As someone who’s in charge of a business working without or with a limited number of employees, you should literally put your blood, sweat, and tears into it, as Elon Musk puts it. Otherwise, you’d be an investor rather than a business owner.
What comes after hobby status
After the Internal Revenue Service decides your business isn’t an actual business and it’s a hobby, you immediately lose the ability to claim deductions for business expenses and losses on your federal income tax return.
This became more prominent after the Tax Cuts and Jobs Act of 2017. Before the bill, “hobbyists” could limitedly write off the wages paid, advertising costs, depreciation and amortization, and insurance premiums under miscellaneous itemized deductions.
How to prevent business from being classified as a hobby?
If your business is legitimate, keeping extensive records of not only your expenses and receipts but the work you put in can show the IRS your ambitions. In the case of an IRS audit, these will come in handy as you’ll have proof to present to the agents that your business is legitimate and far from being a hobby.