Depending on the size of your small business, one of the things you’ll need to consider is whether it actually counts as a hobby in the eyes of the IRS. If the IRS determines that you are engaging in activities that are not for profit, you might have different taxable income or lose some of the losses you want to write off. Here are some of the factors that will determine the difference between a hobby and a business for tax purposes.
Understanding Hobby Loss Rules
The difference between a hobby and a business is discussed in the hobby loss rules that the IRS maintains. While it used to be applicable for things like farming, it has come into play in a much bigger way today thanks to ecommerce. Using eBay to unload some old books that you found in your attic is probably not a business, but what if you are using eBay on a regular basis and making thousands of dollars?
Some of the things that determine the difference between a hobby and a business include:
- If there are profits in three out of five consecutive tax years
- The way that you are running your business (if you are engaging in work that other businesses do to make a profit, if you are trying out new techniques or products, etc.)
- Showing evidence of studying or consulting to start the business
- The amount of time and effort that you are putting into the activity, like pulling back from another job
- Past business successes that show your history of entrepreneurship
- Reporting losses many years in a row (although the COVID-19 pandemic may have an impact on this since many businesses posted losses for 2020)
- The proportion between the positives and negatives that you are reporting (minor losses but large profits, etc.)
- Financial status
- The perception of the activity as fun or recreational, as activities that generally aren’t fun are more likely to be considered businesses in the eyes of the IRS
Because so many of these things are subjective, working with an accountant is critical to ensure that you are properly reporting. An accountant can also help you in planning your long-term tax strategy.
Master the Tax Filing Process with Help from MKS&H
MKS&H provides tax and accounting services to businesses of every size and in every industry. We can work with you to make taxes easily and avoid the most common mistakes. Contact us today for a consultation.
About MKS&H: McLean, Koehler, Sparks & Hammond (MKS&H) is a professional service firm with offices in Hunt Valley and Frederick. MKS&H helps owners and organizational leaders become more successful by putting complex financial data into truly meaningful context. But deeper than dollars and data, our focus is on developing an understanding of you, your culture and your business goals. This approach enables our clients to achieve their greatest potential.