In the past we have talked about the gig economy. This is where individuals are earning money from non-traditional sources. We used to call it getting a second job. Sometimes these jobs produce income and sometimes, because of tax deductions, they actually produce a tax loss. I want to talk about side jobs that, in the eyes of the IRS, are actually considered to be hobbies?
Why does the classification matter?
- The reason why it is important is because you can deduct losses for a side business, but you cannot take losses for a hobby. And worse yet, you may have to claim the income and not get credit for the deductions.
What makes a side business a hobby?
- The IRS looks at a number of different factors, but the main thing they look at is whether the business has a profit intent. Most people get into business to make a profit, but you still have to prove to the IRS that it is your intention.
So does the business need to show a profit in order to satisfy the IRS?
- Actually not. Especially at the beginning of the businesses life cycle, the business may not be profitable. There can be many expenses early on and it may take a little while for the sales to catch up.
Does the IRS have any rules of thumb?
- Although not official, there is a general rule that says if a business reports a profit for three of the last five years (including the current year), the IRS will presume that it is a for profit business.
- So on the other hand, it the business shows a loss for three of the last five years, the IRS will go into the process assuming it is a hobby and it is up to the taxpayer to prove otherwise.
So a business that consistently shows a loss is a hobby?
- Not necessarily. We have had businesses that have shown losses for a number of years and we can still make the argument that they are for profit.
How does that work?
- In these businesses, the owners are constantly taking any positive cash flow and putting it back into the business to make the business better. It could be upgrading or buying better equipment or putting money into a better sales approach.
- The IRS is not automatically going call a business a hobby if the owner can show that they are making legitimate efforts in order to make the business profitable.
What else can a business owner do to show they are in it to make a profit?
- Show that you carry on the activity in a businesslike manner.
- You are making changes to become more profitable.
- You are putting in an appropriate time and effort into the activity.
- Show that you depend on the income for your livelihood.
- Any losses incurred are beyond your control.
- You are taking other steps to make the business better including hiring advisors.
Be sure to talk to a tax professional if you have any questions about your hobby or business.
As a partner, I have thorough experience providing tax services to individuals, privately held businesses, nonprofit entities and estates and trusts. I also provide compilation and review services.
