Let’s get one thing straight, there is no such thing as making money and it not being subject to tax.
Perhaps you rebuild motorcycles and then sell them to friends, etc. Taxable income.
Maybe you do wood-working projects and build things for friends and they pay you for it. Taxable income.
Maybe you like to make stained glass decorations for friends, and they pay you for it. Taxable income.
Do you see a pattern here? It’s when you get PAID something, that triggers the taxable reporting event.
The difference between a “hobby” and a “business” is actually pretty simple. A business operates to make a profit. Folks do “hobbies” for sport or recreation, not necessarily to make a profit.
So, what’s the big deal Kelly? Well, a business gets to deduct related expenses against income, but a hobby does not. To put it simply, a “hobby” just reports the income received.
Let’s say you do the following: You purchased some materials and made a rocking chair for grandma. Your materials cost you $400. You, being a generous person, tell Grandma, “just pay me $300.” So, Grandma pays you $300.
If you have a business, you take the $300 payment you received and deduct the $400 of materials cost. You have a business loss of $100 that you can deduct against other income! If you have a hobby, you report the $300 payment, but your deduction for materials is limited to your income. Your profit is $0. You pay no tax, but that extra $100 you lose is not deductible! Unfair you cry! Exactly! That is why the IRS is famous for swooping in and reclassifying businesses as hobbies. It’s all about deducting losses from business activities against other income. If your business makes a profit, the IRS doesn’t care if it’s a hobby or not.
How do you prevent the IRS from winning the “it’s a hobby” argument? Here is a list of key actions you need to be able to demonstrate.
1) Do you carry out your activity in a “businesslike matter” by maintaining a complete set of accounting records?
2) Does the effort you put into the business demonstrate that you intend to make a profit?
3) Do you depend on the income from the activity for your livelihood?
4) Are any losses due to circumstances beyond your control or are normal for startup phase of your type of business?
5) Do you make annual changes to the way you operate to improve profitability?
6) Do you have the knowledge needed to carry out the activity as a successful business?
7) Were you successful in making a profit in a similar activity in the past?
8) Did your activity make a profit in some prior year(s) and how much profit did it make?
One tool that we encourage all our business clients to do is to make up a simple business plan every year. Ask yourself 3 questions (put the questions and answers in writing and sign/date). 1) Where is your business now? 2) Where do you want your business to be in one year? 3) How do you plan on getting there?
Did you hear? Prov 14:23 says, “In all toil there is profit, but mere talk tends 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.