Jul 19, 2010

Hobby Versus Business--A Significant Tax Difference

One of the most powerful weapons in the IRS arsenal is the hobby loss rule. Under this rule, only taxpayers engaged in a bona fide business--as opposed to a hobby--can take business deductions. This means you need to be regularly engaged in an activity and your primary purpose must be to earn a profit. You don't have to show you earn a profit every year. But making a profit must be your primary purpose. Your business can be full time or part time, as long as you work at it regularly and continuously. In contrast, if the IRS decides that you are indulging a hobby rather than operating a business, you will face some potentially disastrous tax consequences. You may still be able to deduct some of your hobby-related expenses but there are serious restrictions and limitations on these deductions.

The IRS has established two tests to determine whether someone is in business. One is a simple mechanical test that looks at whether you have earned a profit in three of the last five years. The other is a more complex test designed to determine whether you act like a business. Under this test, the IRS looks at certain objective factors to determine whether you are behaving like a person who wants to earn a profit. The most important of these are that you act like you're running a business, you have a certain amount of expertise in the area, and you spend sufficient time and effort on the activity.

For more information, see Home Business Tax Deductions; Keep What You Earn, by Stephen Fishman (Nolo).