Among all the social media posts and email you get each day, not only do you get updates from family and friends requesting you participate in their children’s fundraisers, you probably also see promotions for your friend’s side businesses. In Forbes, Tony Nitti called these businesses a “tax shelter for the middle class.” Yet, there can be many tax concerns for businesses like a friend who, outside of his day job, runs JP BBQ in Elk Grove, offering catering and occasional drive–thru dinners. The IRS may consider such companies hobbies rather than businesses which means the “hobby loss” rules (section 183 of the IRS tax code) apply.
To be considered a business, a company must be in business to make a profit; they are not able to use a loss in one business tooff-set taxes they owe elsewhere. Tony Nitti uses the example of Cecile Barker, creator of the group Peaches and Herb. Barker left the music business and went on to other ventures, but later created a new music company. Even though he owned the capital and worked full time in the business, the IRS still classified it a hobby. This meant that the business could only deduct expenses up to the income the music business made for the year, Barker could not offset his losses in this business with his profits from his other ventures.
Barker’s story is typical for businesses classified as a hobby: the owner has had success in another field and then decides to create a new business venture. Often the recreational or personal nature of the new business may lead to questions of intent: does the business owner intent to make a profit or is this just for fun? Businesses targeted by hobby loss rules often include such things as horse breeders, multi-level marketing distributors and catering, like the barbeque business mentioned above.
While the IRS requires taxpayers to report their income from hobbies, the rules for reporting income and expenses depend on whether the activity is classified as a hobby or a business.
Use the nine questions from the IRS to evaluate whether your activity is a business: https://#.irs.gov/faqs/small-business-self-employed-other-business/income-expenses/income-expenses. It is important to review all facts and circumstances about the activity since no one factor determines the status.
In our experience, people risk the largest exposure of the IRS determining they are a hobby when they are not carrying onactivities in a businesslike manner. Consulting an attorney to better understand the requirements of running a business is a step many business owners overlook. Furthermore, consulting with an attorney can also be referred to as consultation with an expert, one guideline the IRS uses to evaluate the activity.Besides failing to consult with an expert, another symptom of not running the business in a businesslike manner is failing to establish separate bank accounts for the business. Business bank accounts should then be reconciled and financial statements generated to reflect the assets, liabilities and net income of the business. To fulfill this objective, it is usually best to hire a bookkeeping firm. This allows you to focus on growing the business and receiving monthly financials to demonstrate your intent to be profitable.
With the time you spend or will be spending running your business,the goal should be to maximize your investment by being profitable. Concerned that the IRS might determine your business a hobby? Contact us and we can review your business to see what changes are necessary to put your business on the right path.