You say you have a business, but does the IRS? The answer will determine whether you can deduct expenses from income.
Why is this even an issue? Well, with a business, you can deduct expenses from income. You can even have negative business income, which can offset other taxable income, such as from a spouse's job or other income, and this is called a net loss.
But if what you have is a hobby, you’re not allowed to deduct hobby expenses. And you still have to report the hobby income.
It can be tempting to try to pass a hobby off as a business, so the IRS looks carefully at whether you have a true business or only a hobby.
How Does the IRS Determine a Business?
The IRS has a list of factors for determining whether your pastime is more business than hobby. No one factor is decisive. The IRS says all facts and circumstances are taken into account. Here are the most common factors:
- Do you carry on the activity in a businesslike manner?
- Do the time and effort you put into the activity indicate that you intend to make it profitable?
- Do you depend on the income from the activity for your livelihood?
- Are your losses due to circumstances beyond your control, or are they normal in the startup phase of your type of business?
- Do you change your methods of operation in an attempt to improve profitability?
- Do you, or your advisors, have the knowledge needed to carry on the activity as a successful business?
- Were you successful in making a profit in similar activities in the past?
- Does the activity make a profit in some years? If so, how much?
- Can you expect to make a future profit from the appreciation of the assets used in the activity?
The IRS assumes that an activity is for-profit if it makes a profit in at least three of the last five tax years, including the current year. (If you're breeding, showing, training or racing horses, that range is two of the last seven years.)
Report business income and expenses on Schedule C, Profit and Loss from Business.