Tax Advantages of Turning a Hobby into a Business

Many Americans dream of turning their favorite free time activities into money-making ventures. Creating a successful and profitable business is seldom easy, but the Federal government offers tax incentives to business owners that could make converting an avocation into a business start-up an effective part of your overall tax planning strategy. If you are thinking about turning your hobby into a business, you should, however, realistically appraise your chances of building a profitable enterprise before you declare yourself a business owner.

 

Because the tax breaks associated with business ownership can be generous, the Internal Revenue Service (IRS) requires filers to follow certain guidelines before claiming on their tax return that their hobby is, in fact, a business. The IRS recently warned that the “incorrect deduction” of hobby expenses accounts for as much as $30 billion per year in unpaid taxes and cautioned taxpayers against claiming tax breaks for activities that do not meet its definition of what constitutes a business.

In determining whether your activities can be defined as a business for tax purposes, the IRS will want to see evidence that the amount of time and effort you are putting into the venture indicate an intention to make a profit. You may also be asked to show that you have earned a profit from conducting similar activities in the past, and that you or your advisors have the knowledge necessary to carry on the activity as a successful business. While many start-ups incur losses in the early stages, the IRS may require you to demonstrate that these losses are due to circumstances beyond your control and to provide evidence of a willingness to change your methods of operation to improve profitability. To qualify for tax purposes as a for-profit business over time, the IRS may wish to see that the activity has generated a profit during at least three out of the last five tax years.

Fortunately, clearing these hurdles may not be as difficult as it may initially appear, even if you are a first-time business owner or the scale of your business is very small. While the IRS will want to see that you have put effort in to building the business and that it provides a source of income, you do not have to quit your day job and make the new business your full-time occupation in order to qualify for tax breaks. Provided setting up your business does not require a large investment of capital, making a profit in most years should be an attainable goal. You can establish a profit motive by taking relatively inexpensive steps to market your products or services, such as running advertisements online. 

Best of all, many of these expenses become deductible once you have established a business. The IRS defines an ordinary expense as one that is common and accepted in your trade or business. Turning your hobby into a business also allows you to offset losses that you incur on transactions against profits earned on others. Even if your main source of income is not from the business, claiming business expenses and losses can be used to reduce your overall taxable income.

Generally, taxpayers are permitted to deduct ordinary and necessary expenses for conducting a trade or business. What qualifies as ordinary or necessary will vary according to the business. Provided they are directly related to your business activities, you may be able to write-off entertainment and transportation expenses. You may also be able to hire your children to work for the business, thus shifting income to a minor child subject to lower tax rates. If you have a home office and equipment that are used exclusively and regularly for business, you could qualify for deductions for the business portion of property taxes, mortgage interest, rent, utilities, insurance, depreciation, maintenance, and repairs.

Setting up even a small business often involves completing some paperwork. Depending upon the type and scale of your business, you may have to file papers with state and local authorities to register for sales and other business taxes, and to obtain any relevant licenses or permits. As a self-employed individual, you will have to pay income and self-employment taxes as estimated installments on a quarterly basis. If you have employees or are operating as a partnership, you will have to obtain an employer identification number (EIN) from the IRS. Your accountant can help you with these tasks and advise you on selecting the business entity that best suits your needs. While most businesses that grow out of hobbies operate as sole proprietorships or partnerships, you may wish to incorporate the business or form a limited liability company (LLC) once the business is more established in the marketplace.

To better demonstrate that you are taking your business seriously, consider drawing up a formal business plan that outlines how you intend to operate and grow the business. Thorough and accurate recordkeeping is essential, both for claiming deductions and for proving to the IRS that you are carrying on the activity in a businesslike manner. Set up a separate bank account for the business, and apply for a separate credit card for paying for business-related expenses. Attending industry events and subscribing to trade publications can also provide evidence of your investment in the business. Separate phone lines, business cards, dedicated company stationery, and marketing materials can also be useful in proving that you are operating a for-profit business.

 

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