Does the IRS consider you in business or a hobby?
Having a small business gives you access to a lot of Federal and State tax deductions but the IRS has to determine if you are in business or a hobby. If they find that you have a hobby instead of a business that will make you unable to take the business deductions and you may be required to pay the IRS back for the business deductions taken in the past.
How can you avoid this issue?
For tax purposes a business is any activity in which you can show your goal is to earn a profit.
All you need to do is prove to the IRS that your goal is to earn a profit, but as with most tax issues it can get very complicated.
How does the IRS determine if I’m have a business or a hobby?
The IRS uses two test to determine if you are a business or a hobby, the “Profit” test and the “Behavior” test. Meeting the requirements for either test can help you show your in business.
You don’t have to earn a profit every year your in business, as long as you show that your main purpose was to make money. If your business shows a profit (of any amount) in 3 out of 5 consecutive years the IRS usually will consider your in business. You just have to show that your gross income from your business was higher then the tax deductions you took for it.
Sounds simple right, but wait.
The trick is the IRS doesn’t have to wait for the first 5 years after you have started your business to decide if your in a business or a hobby. They can audit and classify your venture at any time.
Careful year end planning may help your business show a profit. Holding back on paying your experiences and buying new equipment until after the new year, asking your customers to pay their bill before years end can also help.
You can also prove you are a business by behaving like a business. If you can show that you are running your business as a business even if you do not make a profit the IRS can classify you as in a business.
Here are several things you should do to help your business pass the behavior test.
Working on your Business
Showing a regular investment of time working to grow your business, it doesn’t have to be full time, a few hours a week spent actively working on your business. Keep a time sheet listing your time spent working on your business with a short description of what you did. It doesn’t have to be to detailed, just a few notes each week on a calendar. Think of it as your time card for work, if you don’t list your time you don’t get paid.
Keeping good records of your spending and earnings each month can show you are tracking your finances. Again you don’t have to have a complex bookkeeping plan in place when you are starting out. But you should keep all your receipts and check ledgers and a simple spread sheet showing what you are spending for your business.
Get Business cards
This sounds old fashion but when talking to potential customers handing them your card with your contact information looks professional and you will insure they will have your information. And it’s a lot easier then having to write it down for everyone you talk to.
Have a marketing plan
Developing and implementing a marketing plan for your business will show you are trying to attract customers and the cost of the campaign can be recorded as a business expense.
Write a Business Plan
Having a written business plan showing your goals for your business is a must. It shows you are building a business and not just having fun. It will also be needed as your business grows to get financing and show potential investors show what you are building.
Keep it simple to start just cover what your goals are for a set period of time, the first couple of years. As your business grows so will your business plan.
Have a bank account in the business name
This will show a separation between your personal and business funds. Make all payments for your expenses from this account and deposit any payments you receive in the business account. This will show you are conducting business and will look more professional to your customers.
Get a website
Today having a web presence is more important then ever, if a customer can’t find your business online they may never know about you. It doesn’t have to complicated to start just having the basic information about your business, what you have to offer and how to find your business. Google My Business is a free service that will give you a free Google + business page and a Google search presence. You can configure your business page to show pictures of your business, a virtual tour, what specials you are having. You can make posts about your business letting visitors know about your business and why they should come in. Your business will have a pin on Google Maps showing your address and directions.
People in a business usually have some knowledge of the business before they start. Even if you are not an expert in your business when you start your will learn and become an expert as you progress and you will want to show you are learning. Taking classes and attending seminars on the subject are excellent ways to increase your knowledge, save the record of attendance for your records and frame any certificates you receive. Showing that you are advancing your expertise can prove your in a business.
Profits and Assets
Earning a substantial profit even after years of losses can help show your goal is a profitable business and trying to make a go of it. On the other hand a few years of small profits after years of investment and loss can show that you are not in it for the money.
Part of your profits can be in your business assets. If you have assets that will grow in value over time such as land or buildings their value can be considered profits.
You don’t have to meet all of these steps but you never know what the IRS will look for. Behaving like a business can help you avoid being classified as a hobby even if you do not meet the Profit test.