When it comes to taxes, you know the rules we all have to follow are boundless. And when you have a business, go ahead and factor in twice the amount of rules that need to be tended to. With a business, the origination, focal point, execution, and monies earned and spent all factor into how it can be considered on your tax return IF it can be considered.

How does the IRS classify an activity as a hobby or a business?

To begin, it is important to define the activities involved. A business will operate to turn a profit from the activity conducted, whereas a hobby is an activity one partakes in either recreational or as a sport without the intention of making a profit.

It is possible for an enterprise to begin as a business venture but later be designated by the IRS as a hobby. When the IRS classifies an activity as a hobby or business, they take into consideration several factors. The primary factors considered are:

• Is the activity conducted in a businesslike manner with accurate records maintained?
• Is the taxpayer taking the necessary steps to ensure the business is profitable? For instance, marketing, record keeping, and having a written business plan.
• Is the income earned dependent on maintaining a taxpayer’s livelihood? Is the activity pursued full-time or part-time?
• Are losses normal for a startup of the business or due to circumstances beyond the taxpayer’s control? Circumstances beyond one’s control would include weather occurrences (like a drought or natural disaster), fire, loss from theft, or economic impacts.
• Does the taxpayer change operation methods to improve or boost profits? Is the taxpayer working to promote, advertise, and obtain necessary products, or supplies to enhance profitability?
• Does the taxpayer have the correct knowledge required to perform the activity as a successful business?
• Has the business made a profit for three to five consecutive years, and what amount of profit has been made?
• Has the taxpayer been successful in making a profit with similar activities in the past?

When the IRS factors the answers to these questions, a determination is made regarding the activities being of a legitimate business or of a hobby. If the IRS determines the business activities claimed on your tax return are actually related to a hobby, all expenses claimed against any income earned will be discredited, typically causing a tax consequence to occur.

My activity has been classified as a hobby, now what?

Deductions for a hobby must be claimed on Schedule A of Form 1040 as an itemized deduction. The IRS does have rules (go figure!) on how the deductions are taken and dictate a specific order, which is as follows:

1. Personal and business activity deductions such as mortgage interest and taxes, MAY be taken in full.
2. Deductions that result in basis adjustment. Examples include insurance premiums, marketing, and wages so long as the gross income is more than the deductions outlined in the first deduction category listed above.
3. Deductions that result in reduced property basis, such as amortization and depreciation, if the gross income is more than the deductions outlined in the first two deductions.

When a taxpayer receives income from an activity performed without the intention of making a profit, in other words, a hobby, the income must be reported on Schedule 1 of Form 1040.

To determine if your activity is a hobby or business, or if you intend for it to remain a hobby and wish to ensure you are following IRS guidelines, it is always recommended to seek the advice of a professional. A tax professional will be able to walk you through the required guidelines to ensure you are not deducting incorrectly and all income is reported as required. The Golden Lion Tax Solutions team can serve as an excellent resource for you! Over the years, our team has helped thousands of clients resolve their tax account concerns, some of which have been due to the reclassification of a business to a hobby. We can help provide you guidance to ensure you are operating and reporting your business properly to avoid any classification switch, and have the knowledge and expertise to challenge any classification change posed by the IRS.

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Disclaimer: There are requirements that must be satisfied in order to qualify for some of the tax solutions we discuss on our website. Not all of our services will be suitable for every client. Golden Lion Tax Solutions is here to help you find the most appropriate solution to fit your situation.