The IRS has very clear guidelines on the difference between hobbies and businesses. The reason for the guidelines is to help taxpayers determine what they can and cannot deduct as expenses.
According to the IRS, in order to make this determination, taxpayers should consider the following:
Does the time and effort put into the activity indicate an intention to make a profit?
Does the taxpayer depend on income from the activity?
If there are losses, are they due to circumstances beyond the taxpayers control or did they occur in the start-up phase of the business?
Has the taxpayer changed methods of operation to improve profitability?
Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
Has the taxpayer made a profit in similar activities in the past?
Does the activity make a profit in some years?
Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?
We recently had a meeting with a number of Medical Doctors that are in the process of launching a business and as can be expected with most startups the losses in the first year will be substantial. The initial investment is in excess of $7,000,000.00, although the actual amount is not relevant in this analysis. Their main goal is to ensure the losses will offset their business income from other activities and not be deemed a hobby by the IRS. No one would ever accuse a Medical Doctor of being a hobby rather than a business but the point is, the recommendations are similar for those who want to avoid having the IRS rule your business losses were not business related but simply a hobby, which will result in the losses being disallowed.
To ensure the IRS sees your undertaking as a business rather than a hobby we recommend the following:
1) Establish an Internet presence.
2) Develop a Business Plan. Judges in Tax Court love business plans
3) Consult Independent Professionals: CPA, PFS and a Corporate Attorney.
4) Prepare profit projections.
5) Conduct a market analysis.
6) Establish an accounting system.
7) Request a Federal Identification Number.
8) Conduct an Entity Selection Analysis: S Corporation vs. LLC
9) Prepare a formal budget and break-even analysis.
10) Keep separate personal and business records.
11) Do not combine personal activities with business to avoid the perception of deriving pleasure or entertainment.
12) Invest a significant amount of time conducting the business activity.
13) You must have an actual objective of making a profit.
14) If your business made a profit in any three out of the past five consecutive years, it is presumed to have a profit motive. This means that if you claim a loss for the third straight year after starting your business, you may be inviting an audit.
15) You maintain accurate books and records and used them to improve the performance of a losing project.
16) Business cards, a well-maintained set of books, a separate business bank account, current business licenses and permits, and advertising or other marketing efforts will all help to persuade an IRS auditor that your activity really is a business.
17) Complying with Local Business and State Rules: City Business License and Permits and Sales Tax Identification Number could help your case.
18) Lastly, in case of an audit, let your tax advisor do the talking.
Palma Financial Services has over 15 years experience with these tax rules and regulations. Call us for a no-pressure, free consultation. Your financial security is our #1 priority.