Hobby Business Rules

Be ready to prove your hobby is a business if you want to write off your hobby losses.

For some small business owners, their home business or sideline business is more a labor of love than a reliable source of income. This is most often the case when the owner has other means of financial support -- such as a regular job or a working spouse -- that allows the microbusiness to continue, even though it makes little or no money. These types of tiny businesses are usually run from home (renting an office would be too expensive) and are often based on semi-recreational activities near and dear to the owner, which has earned them the nickname "hobby businesses."

There are as many types of hobby businesses as there are hobbies. A basement jewelry studio, a jazz band for hire or an antique refinishing business might all qualify. The owners would probably continue to make jewelry, play jazz or restore antiques on their own time and money, but they are trying to turn their hobbies into profitable businesses (or at least deduct their expenses or losses from their income to lower their tax bill).

Deducting Losses From Your Business

For most regular businesses, more than a year or so of losing money is a cue to close up shop. But if you love doing whatever you're doing, it might make sense for you to stick with your losing business rather than fold it up. That's because an unprofitable business can be a "tax shelter." If you have another source of income, the losses from your hobby business -- including everyday expenses and depreciation on capital assets -- can often be used to offset your other taxable income. That can not only lower the amount on which taxes are calculated, but may also drop you into a lower tax bracket.

Of course, most entrepreneurs would much rather earn a healthy profit than lose money with their business. And the savings made possible by a tax shelter do not always justify continuing a marginal or losing business. But they definitely can make a difference when you're deciding whether or not it's worth it to keep your unprofitable -- but enjoyable -- business going.

For example, take the case of Kay and her husband Reza. Reza earns a salary as a chef in a local restaurant, and Kay has no outside income. They file a joint tax return. Kay has a passion for plants, and decides to try making a business of selling some of the hundreds of plants she grows and propagates in her backyard greenhouse. After she spends thousands of dollars on exotic plants, better lighting equipment and permits, the greenhouse heater goes on the fritz and over 300 of her expensive exotic plants die. Her expenses for the year total $10,000, and she has sold only $200 worth of plants.

The silver lining for Kay and Reza comes at tax time, when they deduct the $9,800 loss from their joint taxable income of $65,000. By reducing their joint taxable income to $55,200, they not only are taxed on less income, but their tax bracket is reduced from 28% to 25%.

Here's the catch: If Kay had not intended to make a profit, the IRS would not have allowed Kay to use the loss to offset any income, other than the $200 she received from plant sales.

Proving Your Business Is a Business

If you consistently use your business as a tax shelter, deducting your losses from your other income year after year, you'll likely catch the attention of the IRS. Unsurprisingly, you're not allowed to deduct losses from your favorite activities -- only the losses of a legitimate, profit-motivated business. So before you start claiming deductions for the costs of your favorite art projects or toy car collections, make sure your venture will pass IRS scrutiny as a real business in case you're ever audited.

The deciding factor in determining whether a business is legitimate is whether the activity is engaged in "for profit." In other words, you must prove to the IRS that you're trying -- not necessarily succeeding -- to make a profit with your venture. The IRS uses several different criteria for deciding whether or not your business truly has a profit motive.

One popular test for determining profit motive is called the "3-of-5" test. If your business makes a profit in any three out of five consecutive years, it is presumed to have a profit motive. This means that if you claim a loss for the third straight year after starting your business, you may be inviting an audit.

While the IRS gives a lot of weight to the 3-of-5 test, it is not conclusive. In other words, if you flunk the 3-of-5 test, you still may be able to prove that your business is motivated by profit. You can use virtually any kind of evidence to illustrate your efforts to conduct your activity as a business in pursuit of profits. Business cards, a well-maintained set of books, a separate business bank account, current business licenses and permits and advertising or other marketing efforts will all help to persuade an IRS auditor that your activity is in fact a business.

Complying With Local Business Rules

Many cities impose taxes on small businesses and require them to go through some sort of registration process, and counties often have similar requirements for businesses in rural areas. Technically, these rules apply to any money-making activity within the area -- even if you don't intend to claim any federal or state tax deductions for your hobby business. Also, if you sell goods, such as homemade jewelry, your sales will be subject to state sales taxes, which means you'll have to apply for a "seller's permit."

In practice, many tiny hobby businesses -- so tiny that the word "business" seems excessive -- might be able to get away unnoticed. Even so, you should be aware that depending on your local rules, you could be penalized if you're caught doing business without having gotten the permits or licenses required by your state or local government. These penalties may include fines and any back taxes that apply.