Do You Have a Business or a Hobby?
One of the greatest advantages of small business ownership is the opportunity to do what you love and in large part the ability to do it your way. But one of the caveats that small business owners must be aware of is that only businesses engaged in for profit may deduct expenses. If your endeavor is merely a hobby, the income is still reportable on your tax return, but your expenses are not deductible. If it is shocking to you to read this, keep in mind that substantial changes were made to the hobby loss rules under the 2018 Tax Cuts and Jobs Act.
What is a Profit Motive?
A business activity engaged in for profit is one in which the taxpayer is legitimately trying to produce income—taxable income as far as the IRS is concerned. A business with the motive of being profitable involves two basic assumptions. The business owner is trying to maximize money/revenue coming into the business, while simultaneously trying to minimize money/expenses going out of the business. If we think about a large publicly-traded company like General Motors, for instance, GM is constantly striving to produce its cars at the least expensive price while still maintaining the quality of its vehicles in an effort to increase sales. Ultimately the goal is to deliver profit and value to its shareholders. Though small businesses operate quite differently from large publicly traded companies, the concept of the profit motive is the same. A small business owner who is engaging in an activity for profit will be actively trying to generate revenue and minimize expenses as much as possible. This natural process would generally result in the production of taxable income.
But What Happens If There Is a Loss?
It is definitely possible for a business owner with a legitimate profit motive to wind up with a loss. Most small business owners know that it “takes money to make money” and sometimes investments into a business endeavor can have significant costs, especially in the start-up phase, as the business undergoes a transition, or even when factors happen outside of a business owner’s control (i.e. Covid-19). However, throughout all phases of business ownership, the decision-makers in a business being operated for profit will evaluate the challenges that the business encounters and make decisions in an effort to increase profitability. The business owner will be constantly looking at ways to increase revenue and decrease expenses. At the point in which the business owner is no longer motivated to seek profit, expenses related to the business are no longer deductible, and the losses generated by the activity cannot offset other income that the taxpayer may report on his or her tax return.
The Hobby Loss Presumption
The IRS presumes that an activity that generates losses during three out of five consecutive years is a hobby. The burden is on the taxpayer to establish that the activity is not a hobby if he or she wishes to deduct expenses and/or losses associated with that activity. The IRS looks to some of the following factors to determine whether a business is being operated with a profit motive:
- The amount of time and effort the taxpayer spends carrying on the activity
- Whether the taxpayer depends on the activity for his/her livelihood
- Whether the taxpayer has successfully run other businesses in the past or has other successful activities simultaneously
- The expertise of the taxpayer and his/her advisors
- The potential for asset appreciation over time (i.e. in real estate or investment activities)
- Elements of personal pleasure or recreation
How to Prevent Your Business from Being Classified as a Hobby
One of the best ways to prevent a business with a profit motive from being classified as a hobby by the IRS is to keep detailed and accurate books and records. Generally, the more detail the better, but definitely weigh the time and cost of the detail against the benefit that it creates. In today’s times, the incorporation of apps and software can greatly assist a small business owner with recordkeeping. Maintaining a separate bank account, setting up an LLC, tracking mileage, and incorporating the decision maker’s contemporaneous thoughts via meeting minutes/notes can also be extremely helpful. Additionally, obtaining professional expertise early on and throughout the endeavor can be a business owner’s greatest asset. Businesses that are looking to increase profitability generally consult with individuals such as attorneys, CPAs, and marketing professionals in an effort to increase profitability. Evidence of these investments, and taking the advice of such professionals, can have a substantial impact on whether the taxpayer is successful in an audit for a hobby loss issue.
What Should I Do if I am Audited for a Hobby Loss Issue?
Because I assist my small business clients with a wide variety of different services, I do not constantly work on tax audits. However, I do handle them periodically and have seen the IRS either fishing for this issue or explicitly auditing for it several times. Each time I have seen it, the filed returns on their face suggested that the issue would arise. Most often, these were self-prepared returns that a client filed where either no revenue or a very small amount of revenue was reported, but reported expenses were massive or unreasonable on their face. What is interesting about many of these cases is that oftentimes the initial IRS notice started out somewhat benign, but based on the taxpayer’s responses to the inquiry the IRS expanded the scope to increase the audit requests and/or the number of years under audit. By the time the taxpayer contacted me, the matter had become significantly more serious than the initial notices that were sent out.
My best advice for a taxpayer who receives an IRS notice with suggested adjustments or questions regarding a tax return is to hire a professional as early as possible in the process. This professional will look at the tax returns in question, the notices provided, and assist the taxpayer with advice on potential options, and in some cases, the professional may be retained to communicate directly with the IRS on the taxpayer’s behalf. Depending on the issues involved, an attorney is almost always the best way to go if you choose to hire a professional, as these civil cases can sometimes be referred by the IRS to the Department of Justice if they arise to the level of criminal offenses. Attorneys have the highest level of privilege in their communications with taxpayers and cannot be compelled to testify against their clients in criminal proceedings.
If you are struggling to make your small business profitable or have received a notice from the IRS with questions regarding the activities of your business or adjustments to your filed returns, please contact me using the form below.