Taxpayers frequently state my business is “just a hobby”. Well the IRS wants to remind you that you need to follow certain guidelines and truly determine whether your activity is a business or a hobby. This will determine where you will report the income and the expenses on your tax return!
The best way to approach this is to determine if the activity qualifies as a business, and what the limitations apply if the activity is truly not a business. According to IRS estimates, incorrect deduction of hobby expenses account for a portion of overstated adjustments, deductions, exemptions, and credits that add up to $30 BILLION per year in unpaid taxes!
Generally, taxpayers may deduct ordinary and necessary expenses for conducting a trade or business. Ordinary = common and accepted in that trade or expense. Necessary = appropriate for that business. An activity qualifies for a business if it is carried on with a reasonable expectation to earning money.
Some determining factors:
- Time and effort put into activity
- Does taxpayer depend on the income
- If there are losses, are they due to circumstances beyond their control or was it from the start up
- Change of accounting methods to improve money
- Taxpayer have the knowledge to carry on this type of business
- Has the activity made money in the past
- Can the taxpayer expect to make a profit in the future?
The IRS expects profit 3 of last 5 years; 2 out 7 years for breeding, showing, training or racing horses.
So if the activity is NOT for profit, losses cannot be taken to offset the income. Deductions for the hobby will be reported on Schedule A.
TIP: Your part time Mary Kay, Avon, Pampered Chef income could be subject to the hobby loss rules.
Always discuss with your tax professional before starting any type of business.