Do You Have a Business or a Hobby?

Your ability to prove whether or not you have a business can greatly impact the deductions you’re able to take on your tax return for expenses you incur in carrying out your activities.  In this article we discuss a few of the factors the IRS considers when determining if you have a business or a hobby.  There is no easy line that can be drawn in making such a determination, which is why a multitude of factors are considered.

 1. Do you have the knowledge to carry out the activity as a successful business?

You’ll have an easier time showing you’re capable of making your business a successful venture if you are licensed or certified in your line industry and/or have experience in your line of work. Additionally, being able show you are working with a professional like a CPA for expert guidance in your business helps to show it’s more than a hobby.

2. Losses are usual in the start-up phase for your type of business or are due to circumstances beyond your control. 

Not all businesses incur losses during their first years.  Businesses that do not require large investments in equipment to get started, for instance, would be more likely to be profitable in the first year versus a company who does.  You can show an understanding your industry and an anticipation of early stage losses by having a business plan.  Losses could be due to circumstances beyond your control.  A great example of this would be the overall effect the recent Pandemic had on millions of businesses across the world.

3. You’ve made changes in your methods of operations to improve profitability.

Creating new strategies in the face of failure of a particular product or service is necessary for success.  Strategic planning is not usually engaged in when an activity is a hobby.

4. Assess if the activity has made a profit in some years and if so how much. 

5. Is there enough income from other sources to fund the activity?

If you are taking large losses for “business” activities, be aware that such deductions often come under scrutiny.  For instance, red flags can be raised when these losses greatly exceed the income shown on your tax return.  If you don’t have income, you should be able to  show a loan, gift or inheritance or other source of funds was used to invest in your activity.