Now how many folks, who are spending more time in their business than they ever would just being somebody else’s employee, would call that business “just a hobby?”
Well the IRS just might want to call your business a “hobby.” Why would they do that? Simple, by doing so, it disqualifies ALL related expenses and only the GROSS income is taxed.
If you had a business with $100,000 of GROSS income and $110,000 of expenses, you don’t normally owe any tax for that business activity. In fact you get to write off the excess $10,000 of expenses against other income (like wages?).
If the IRS came swooping in and said, “Sorry! We don’t’ think you are operating a ‘business’ so we are reclassifying it as a ‘hobby’ and disallowing all related expenses.” Now you have to pay tax on the GROSS income of $100,000 (at 25% would be a tax of $25,000). Get this. You lost money, but you have to pay $25,000 in tax to the IRS.
How do you avoid this terrible action by the IRS?
- Treat your business like any other business owner would, trying to make a profit. Write an annual business plan, going over the mistakes (or lessons) learned and how you plan on reversing the negative impact of them in the coming year to make a profit. Give that plan to your CPA every year. (This helps document that you did the plan every year, and gives you some opportunity to get input from your CPA, which also impresses the IRS that you are trying to make a profit.)
- Document your expertise in this business. Do you have prior experience? Do you have a special certification?
- If your business involves personal pleasure or recreation, then keep a log of personal use of the business assets and do NOT deduct that personal portion as a legitimate business expense. (Boat excursions? Airplane operations? Hunting guide? Horse breeding? etc.)
- If the business has ever had a profitable year, be able to demonstrate that to the IRS. (Usually a tax return showing such is all you need. So save all your tax returns.)
- If you have had prior success in this type of business, have proof of that handy. (You might have done that while being an employee, have something to demonstrate your prior success. You may have had a prior business that was sold, etc. that was profitable. Have business financials and tax returns to demonstrate this.)
The key fact to remember is that the IRS only comes in to reclassify a business as a hobby if you are showing a loss on the tax return. So, given that your real goal in having any business, is to make a profit, just make that happen as soon as possible.
Did you hear? Prov 14:23 says, “In all labor there is profit, but idle chatter leads only to poverty.”
Kelly Bullis is a Certified Public Accountant in Carson City. Contact him at 882-4459. On the web at BullisAndCo.com Also on Facebook.