Posted by Abundant Wealth Planning LLC

Hobby, Trade, or Business in the United States? Why it is important to know the difference

Hobby, Trade, or Business in the United States? Why it is important to know the difference


Everyone seems to have side hustles these days, but is your side hustle a hobby, trade, or a business? Even if you consider your hobby business in the United States, the IRS may disagree with you.

Knowing the distinction between business, trade, and hobby is important, and making mistakes can have serious consequences. Whether you're just trying to make money, diversify your income stream, or turn your side hustle into a full-time job, make sure you know how to avoid the IRS from questioning your status.

Learning IRS rules

A business or trade can offset taxable profits with "ordinary" and "necessary" business expenses. A necessary expense is one that is suitable for the business. Ordinary means that expenses are common and accepted in the industry. A sole proprietor who ends up reporting a net loss in Schedule C of Form 1040 can use this loss to offset other income, including wages, dividends, interest, etc.

If you derive income from a hobby (not a formal business), this income should always be shown in Schedule C of your income tax return. Still, hobby-related expenses cannot be deducted from hobby income. Instead, the hobby expenses are necessary because various deductions detailed in Schedule A and the hobby expenses are limited to the sum of hobby income. In simple terms, your hobby cannot generate a net loss. 

A company that has been functioning at a loss for several years risks being challenged by the IRS and recalculating its tax debt in accordance with the rules on loss of hobby. 

Factors to consider

Generally, the IRS will consider the business to be a business if it has made profits for at least 3 of the last 5 years, but many businesses take the time to be profitable or go through downtimes. Fortunately, the IRS considers other factors.

  • Are there elements of personal pleasure or hobby in the activity?

  • Do you have a reasonable expectation of future income?

  • Do you or your consultants have the knowledge and experience to run a successful business?

  • Does it depend on business income?

  • Does the time and effort invested in the business indicate your intention to make a profit?

  • Have you benefited from similar efforts in the past?

  • Have you changed operating methods to improve profitability?

  • If there were any losses, did they occur due to circumstances beyond your control, or did they occur at the start of the activity?

Businesses with elements of fun or personal recreation face great hurdles to overcome hobby loss challenges. The horse-breeding, training, or horse racing companies attract a lot of IRS attention because they are expensive, and only wealthy people pursue them as hobbies.

No one factor determines whether your business is a hobby or a business, but the more proof you have in your favor, the better you will be if the IRS knocks on your door. 

How To Challenge-Proof Your Business

If you are concerned about a hobby loss challenge, you can take steps to protect your business.

  • Develop a business plan and ensure to update it annually.

  • Have the appropriate business licenses, insurance, or certifications for this type of business.

  • If you are doing other full-time work while working for the company, document the time spent working in the secondary company.

  • If you lose money, document your attempts to change direction and improve profitability.

  • Keep bank accounts and credit cards separate.

  • Maintain comprehensive business books and records and use these records to review and improve performance. If you want to improve your billing process, download an invoice template. It will keep you better organized.

  • Show a history of business experience or try to develop experience. Have you studied the sector, signed up for courses, or consulted specialists?

Why It Matters 

In May 2015, the Treasury Inspector General for Tax Administration (TIGTA) released its audit report on IRS methods to identify taxpayers who abuse hobby losses to offset other income costs of up to $ 70 million of poorly paid taxes. TIGTA suggested that the IRS has the information available to identify possible abuses of hobby loss deductions but have not used it. They recommended that the IRS make better use of its investigative resources and agreed to intensify the application of the hobby loss rules.

If the IRS questions your deductions, it can redefine your business expenses as hobby loss and recalculate your tax liability for those years. You will need to increase your taxes and balance interest and accuracy fines up to 20% of the unpaid tax.

The Internal Revenue Services has a long way to go for challenging losses. They can generally back three years from the date the return was filed or the due date of the return, as the case may be, to dispute a return. However, the limitations may be extended in the event of a substantial omission (more than 25%) of the gross income at the time of return. In such cases, the IRS can go back six years from the date the return was due or filed.

The bottom line? If you plan to start a secondary business, run it commercially. Prove yourself that this effort can save you a hefty tax bill and serious headaches for years to come.

Deduction Of Hobby Costs

If it turns out that what you think is a side business is, in fact, a hobby that generates income and not profits, you can always deduct some or all of your expenses, which means it chances are you don't owe income tax.

To deduce hobby expenses, it is necessary to itemize the deductions (complete Schedule A). The IRS has three categories of expenses that can be deducted and must be used in order and only up to the maximum allowed by each.

  • The deductions taxpayers can make for personal and commercial activities, such as interest and taxes on residential mortgages, can be made in full.

  • Deductions that do not involve an adjustment of the real estate base, such as advertising, insurance premiums, and salaries, can be made below because the gross income from the activity is greater than the deductions from the first category.

Deductions on corporations that reduce the ownership base, such as depreciation, are made last, but only to the extent that the gross income from assets is greater than the deductions made in the first two categories. 

Bottom Line

The IRS's application to your hobby loss rules means that if you are running a secondary business, you must treat it as a business and be prepared to prove the claim to an IRS representative. Perhaps the safest way to have a legitimate business that meets eight of the nine criteria for a business, considered a hobby, is to have consistent losses every year. The IRS considers this the biggest indicator that a business is just a hobby.



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