Do you know how the hobby loss rules apply to your home business? There are many aspects of the income tax law that are important for a home business, but an area of the law that is often overlooked are the hobby loss rules.
The IRS is always on the lookout for taxpayers who engage in activities which reduce their income from other sources. You might say that such activities are a “red flag” for an IRS audit. It is up to the IRS examiner to make a factual determination as to whether an activity is engaged in for profit, such that losses from the activity are deductible. As you may guess, the IRS often denies such deductions.
With respect to your business venture, it is up to you to prove that the activity you’re engaged in has an actual and honest objective of making a profit.
When an activity isn’t engaged in for profit, the “hobby loss” rule applies to disallow any loss from the activity.
In this case you can only deduct expenses from a home business to the extent of the gross income it generated. In such a case, the expenses from the activity must be applied in a specific order to offset the gross income from your home business.
Here are some of the factors taken into account in determining whether you are engaged in your home business for a profit:
1. The manner in which you transact your business.
- Do you operate your business in a business-like manner and maintain complete and accurate books and records.Do you run your home business in a manner substantially similar to the manner in which you run other profitable activities of the same nature; orDo you change operating methods, adopt new techniques, or abandon unprofitable methods in a manner consistent with an intent to improve the profitability of your business?
2. Your expertise and the expertise of your advisors.
- The fact that you prepared for your business with extensive study of its accepted business, economic, and scientific practices, or by consulting with advisors who are experts in such practices, and you carry on your business in accordance with such practices, may be evidence that you have a profit motive for carrying on your business.
3. The time and effort you put into the activity.
- Did you quit a job or other business activity to start your new venture? Do you devote most of your personal time and effort to carrying on your business and your business does not have a substantial personal or recreational aspect?
By now you are probably thinking that this is boring and legalese. You may be correct on both counts. But, as you start your new business venture, it is wise to know the tax provisions as they may apply to you.
I found that the more knowledgeable my client was, the easier it was to give correct advice. In all my years as an accountant and involvement in home based businesses, I have yet to see anyone drive many miles to meetings, call people, spend money on conventions and personal growth literature just for the tax deduction. These rules don’t seem logical to me either.
You should make a mental check list and see if any of these provisions apply to you. If so, make a prompt visit to your tax preparer.
In my next article I’ll look at two more provisions relating to hobby losses and look for the silver lining for your home business in all these rules. There is one!
*This article is written to provide accurate and authoritative information in regard to the subject matter covered. The author is not hereby rendering legal, accounting or other professional services. If legal advice or other expert assistance is required, the services of a competent professional should be sought.