There are a few phrases in the vocabulary that compel virtually everyone to immediately take notice and go on high alert. Like termite infestation. Like poison ivy. And like black ice. And indeed, like IRS audit. But that’s a distinct possibility when turning your hobby into a small business. If, that is, you don’t do it right.
Of course, I’m not implying that anyone out there is not paying their fair share to Uncle Sam (and his relatives at the state level). But we all know that IRS audits are time consuming, stressful, and expensive if you need a tax lawyer to help you navigate the process. And you know what? The IRS is perfectly fine with people dreading IRS audits, because it helps with compliance. After all, who is afraid of going to Disneyland (well, unless you get caught on that “It’s a Small World” ride and have to keep hearing that song over…and over…and over again — yikes).
The reason I’m bringing up the specter of an IRS audit isn’t to ruin your day. It’s to warn you that, if you’re planning on turning your beloved hobby into a small business (and then hopefully after a while into a large business), then you need to make sure that you don’t run afoul of the IRS’s rules when you claim deductions and lower your overall tax bill.
The IRS relies on following nine criteria to determine whether a taxpayer’s hobby is a legitimate business:
1. If the taxpayer conducts the activity in a business-like manner, and keeps a complete and updated set of books and records.
Basically, this means that you need to demonstrate and prove that you’re seriously running a business. For example, if you run a party bus company (because you love throwing epic parties), then you properly track party bus rental cost, advertising cost, gas and maintenance costs, and so on.
2. Whether the taxpayer invests a sufficient amount of time and effort to make the business profitable.
This doesn’t mean that you need to quit your day job (in fact as discussed here, you almost certainly DON’T want to that just yet!), or that you need to stay up half the night grinding away at your business just to keep the IRS happy. Rather, what it means is that you need to demonstrate that you’re legitimately working to make money vs. just having fun now and then on your hobby.
3. Whether the taxpayer’s hobby into a small business generates a profit in some years, and how much profit is generated.
There is some gray area here, because many small businesses don’t make a profit for a quite a while. The general understanding, though, is that the IRS wants to see that a business generated profit for at least three of the last five tax years (including the current year). The IRS is a little more flexible if your business involves breeding, showing or training racing horses, in which case it’s usually OK if you turned a profit in two of the last seven years.
4. Whether the taxpayer depends on income from the activity for their livelihood.
Again, this doesn’t mean that you need to quit your day job, and hope that you hit the jackpot. Rather, it means that the IRS is very wary of taxpayers who essentially launch hobby-inspired small businesses as a vehicle to offset tax owed from other sources of income. So no, you don’t necessarily need to rely on the activity for your livelihood in order to satisfy the IRS. But you need to show that you’re not just trying to cut your tax bill (i.e. cutting your tax bill is a consequence, but not an objective).
5. Whether the taxpayer’s business losses are normal or beyond their control.
As noted above, the IRS doesn’t expect every small business to turn a profit in the first year of operation, and in some cases the first few years. But they do expect any losses to be in alignment with statistical norms (e.g. it shouldn’t cost you $50,000 to launch a business when the average startup cost in your industry and marketplace is $5,000). In addition, the IRS is typically fine if your losses were legitimately beyond your control (e.g. if an expensive piece of equipment was destroyed in a natural disaster and you had to re-purchase).
6. Whether the taxpayer makes meaningful adjustments to improve profitability.
I’ve said it before, but I’ll say it again because, well, the IRS keeps saying it: you don’t have to be profitable from day one (or even year one). But if you aren’t making profit, and it’s not because you’re heading nicely along your break-even trajectory, then the IRS wants to see that you made meaningful changes to make more money. For example, if your phone is gathering dust rather than ringing off the hook, you advertised, hired a part-time salesperson, improved your website SEO, started a strategic referral or lead generation partnership, etc.
7. Whether the taxpayer sufficiently qualified to run a successful business.
You may be a magician with a drain snake, and all of your neighbors might come running to you when a clog brings nature’s call to a screeching (and messy) halt. But if you aren’t a licensed, insured and qualified plumber, then the IRS isn’t going to sign-off on your plumbing business. You or your advisors need to have the competence and capacity to run a (potentially) successful business, or else it’s going to be deemed a hobby.
8. Whether the taxpayer has a history of making profit from similar activities in the past.
If you don’t meet this condition, then don’t worry — you’re not automatically going to trigger an audit, and wind up with a big, scary overdue tax bill. Rather, it means that if you’ve made money in the past performing activities that are now part of your small business, then you’re on much stronger ground.
9. Whether the taxpayer reasonably expects to make profit in the future from the appreciation of assets used in the business activity.
This won’t apply if you’re providing a professional service, like web design. But it would apply if, for example, you purchase land to carry out the business activity. In this sense, the IRS is likely to accept that your operations may not necessarily be profitable, if your goal is to sell the land at a later date (e.g. you love horses, you buy land to board and groom horses, the value of the land increases, and you plan on selling the land in the future).
The Bottom Line
As always, make sure that you do your homework and get qualified advice on do’s and don’ts. That means consulting accountants and lawyers, and not the guy at the coffee shop who claims to know all about how the IRS does business (hint: he’s wrong and will be of no help when you get audited — heck, he won’t even buy you a coffee).