Hobby Income vs Business Income

By Tim Frye

The IRS has stringent rules regarding self-employment, and it is for obvious reason on their end. The realm of self-employment allows for a tremendous amount of taxpayer freedom, and the tax reporting regulations rely on the honesty of the individual. So when your client is reporting self-employment income and expenses, the government is naturally skeptical and scrutinizes the taxpayers”s actions extremely closely. One of the ways the IRS limits Schedule C losses is by classifying a taxpayer’s self directed activity as a hobby, and subsequently disallowing certain expenses. Let’s take a look at the IRS’s guidelines and regulations as to the definition of a hobby versus a business venture.

Factors for Determination of Business Income

The inaccurate classification of hobby expenses as business expenses accounts for a good percentage of the $30 Billion per year in unpaid taxes the IRS reports. The IRS allows a deduction for business expense as long as it can be considered “ordinary and necessary” for the conduction of the trade or business. The term ordinary for the IRS means that the expense is a common and accepted one for the taxpayer’s trade. Necessary to the IRS equates to those costs that are appropriate for the business. Business activities are to be transacted with expectation of a profitable outcome. Here are some things that factor in to the determination of business expense.

Time: The time invested into the venture should be sufficient enough to attain a profit.

Dependence: Does the individual rely heavily on income from activity?

Responsibility: Are the losses incurred during course of business the taxpayers fault or are they just start up expenses or out of the individual’s sphere of control?

Alterations: Is the taxpayer improving,changing, and tailoring their efforts in order to avoid claiming losses year after year?

History: Does the taxpayer have a reputable track record of making money from similar business ventures prior to their current activity?

Profit: Is there profits in any years during the business tenure, or is it taxpayer claiming loss year after year?

These are all issues taking into consideration when the IRS is seeking to define an activity as a business or a hobby.

Profitable Time Requirements

The IRS states that you should be in the black for 3 out of the first 5 years upon the germination of your business venture. Once you have claimed losses for the same business beyond 2 years, the risk of audit increases dramatically. It is understood that during the first two years after starting a business there will usually be significant losses incurred. However, after that the IRS expects the taxpayer to get on their horse and realize and report a profit by the third year. Remember to note that this is not a mandatory provision, more like a bowie to let your client know that they have now crossed the IRS threshold of acceptability and are now treading in deeper, murkier waters where the real danger awaits.

Safe ways to avoid Schedule C Audit

Their are ways to safeguard your Schedule C from getting ripped apart by the most pernicious and ambitious of IRS agents. One: You should probably think about recommending to your client to get into a business that suits their talents, and a venture that has a chance of showing a profit within three years. If they have no artistic ability whatsoever and after throwing back one too many one night, your client experiences a drunken epiphany and thinks they should start painting portraits for sale and pushing them on the streets of Venus, they will probably be looking forward to brief but murderous audit in the near future. Two: During the conduction of their business, advise your client to keep precise, accurate, and veracious records so that, in case of an audit, they have the papers to back your claims. Three: Tell them to keep operation costs as low as possible during the first few years, so that, if they do claim losses in consecutive years, theses losses are not so exorbitant that you have the IRS kicking down your door by year three. Good luck! And be careful.