The IRS may categorize your business as a hobby if it declares losses perennially or fails to meet other prerequisites. This reclassification has various implications, including preventing you from claiming crucial loss-related deductions. To reverse the decision, you’ll have to prove that your business had a profit motive.
How Does the IRS Determine Whether You’re Running a Business or Hobby?
The federal tax agency uses the Nine Factors Test to determine the true nature of an activity:
- Do you generally run the activity as a business? The IRS looks at whether you maintain accurate financial records and a business checking account, among other signs.
- Do you invest the time and effort into marketing and other activities that increase the likelihood of turning a profit?
- Does your livelihood depend on earnings from this activity?
- Are the recurring losses beyond your control?
- Have you implemented any changes to reverse the loss-making streak?
- Do you possess the necessary expertise and support from stakeholders to succeed?
- Have you successfully operated a similar business in the past?
- How much profit, if any, have you made during the business’ existence?
- Do you foresee profitable growth in the coming months or years?
The IRS generally applies this test to income sources tied to recreational activities. Examples include dog breeding, writing, fishing, photography, and craft sales. You’re also more likely to be subjected to this business-or-hobby test if your small business is a sole proprietorship, partnership, or LLC. Hobby loss rules don’t apply to corporations.
The Tax Cuts and Jobs Act (2017) prevents hobbyists from claiming deductions on non-business expenses by classifying them as miscellaneous costs. Even so, the IRS still expects you to report hobby income while filing returns.
Can You Prevent a Hobby Classification?
According to the IRS’ safe harbor rule, you run a for-profit activity if it’s profitable for at least three out of five consecutive fiscal years. You can postpone a business-or-hobby determination by filing Form 5213. Apart from preventing an IRS audit, this option grants your business at least two more years to turn a profit.
It’s also advisable to adopt practices that make it easier to classify the business as legitimate. An essential step is registering it appropriately, preferably as an LLC. In addition to giving your entity a professional image, separating personal and business expenses also has tax benefits.
A separate business checking account helps you build a better relationship with creditors and the IRS. Other ways to avoid hobby classification include complying with state and federal tax regulations, paying annual permits, and enforcing regular business hours.
Although some audits are random, the IRS generally performs an audit if it has legitimate concerns about your business. You may trigger an audit if you report substantial expenses with insignificant income or report losses in your tax return to offset other income.
You can lower your risk of an IRS audit and hobby classification by running your business professionally. The best way to implement these solutions is to seek the services of a licensed CPA, enrolled agent, or business advisor. Their expert advice not only ensures tax compliance but also puts you on the path to growth and profitability.