The IRS May Want to Know if it’s a Hobby or a Business

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Small businesses are being established every day. With all the hard work involved they want their fair share of having time to grow and flourish their business. A business emphasis should be on keeping good   accurate records and keeping business accounts separate from personal accounts. These are the main documents that the IRS will review when trying to distinguish between a hobby or business designation. 

If a taxpayer has a loss on Schedule C the hobby rules may become an issue. The IRS may rule the business a hobby if the taxpayer cannot prove his intent is to become profitable. A taxpayer does not want to lose deductions due to poor record keeping because of the high amount of taxes he will be paying on his profit (i.e. 15.3% SE tax, average 25% – 28% Federal income tax, plus state income tax). It can quickly come close to 50% tax. One should hire a knowledgeable accountant / tax preparer when he starts his business or is thinking of starting a business; it will be very beneficial for both. The taxpayer will save money on taxes with good record keeping. The tax preparer will feel more comfortable preparing the return when the numbers have come from verifiable and reliable sources.

Hobby expenses up to the amount of the hobby’s income are generally deductible, if the taxpayer itemizes, on Schedule A line 23, subject to the 2% floor. Hobby losses are not deductible from other income, because a hobby is not meant to make a profit. A hobby, however, can become a business. The IRS’s criteria for determining whether an activity is a hobby or a business is generally determined by whether the activity shows a profit for 3 out of the last 5 years Including the current year (2 out of 7 years for activities involving horse racing, breeding, training or showing). In order to show the IRS that a nonprofiting activity is a business, the taxpayer should maintain the following:

1. Thorough and business-like books

2. Separate business checking account

3. Separate credit cards for business and personal purchases

4. Log book to keep record of business and personal use of such items as computers, charter boats, camcorders, etc.

5. Required licenses, insurance, certification, etc.

6. If operated from home, separate business line for phone

7. A show of change in operations in an attempt to make a profit

8. Research on market trends and technology related to taxpayer’s business

Follow these rules and you should be able to prove that you run a business that is operated for profit.

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