Home Business Taxes: Business vs. Hobby

Home business taxes can get complicated. However, you first have to realize whether the IRS thinks your home business is a hobby.

One of the issues that you might run into as you run your home business is how the IRS views it. It greatly affects the tax deductions you can take for your business. It's especially important in terms of the way your losses can offset your income from elsewhere. Many of those with home businesses use Schedule C to report profits and losses. Losses on Schedule C can be deductible against other income. This helps many home business owners see some tax benefits even as they struggle to get off the ground and make a profit.

However, even if you might see your venture as a business, the IRS might decide that it's actually a hobby. That can be problematic because you can only deduct hobby expenses up to the amount of income that you earn from it. With a hobby, you can't claim losses to the point that you go lower than zero. So, if you spend $500 on your efforts to build a blog, and you only make $100, you can't take more than $100 in blogger tax deductions if the IRS thinks what you're doing is a hobby.

What Makes Your Home Business a Hobby?

In order to determine whether or not the IRS views your home business as a hobby, the first test is how profitable you have been in recent years.

Recently, the IRS released a manual that offers information about whether or not something is a hobby. One of the rules has to do with how often a loss is reported on Schedule C. The activity must show a profit in three out of the past five years if you want it to be considered a legitimate business rather than a hobby. Say you claim losses for two years on your Schedule C and use them to offset the income from your day job. So far, so good. However, if you claim a loss for the third year, the IRS might not allow it and instead classify your business as a hobby.

You will owe for the amount you deducted, plus interest and penalties if the IRS decides that your home business is actually a hobby. These rules also apply to farming when you fill out Schedule F. The only exception is if you are involved in horse breeding. In those cases, you need to show a profit in two years out of the last seven for it to be considered a legitimate business.

Convincing the IRS that Your Home Business is NOT a Hobby

There are ways around the hobby rule, even if you have more than two years of losses in a five-year period. If you can prove that you are working toward turning a profit and that you expect your home business to actually provide regular profits down the road, the IRS might overlook the hobby rule and allow your losses. Some of the things the IRS takes into consideration include the following:

  • Business model: First, show that the nature of your losses is normal for a business. Prove that your business model is solid and losses are expected to disappear over time. The IRS is more likely to allow the deductions on your home business taxes. However, if your business model indicates that losses are likely to continue, the IRS will view it as a hobby.
  • The time you put in: You can have a side business on top of your day job. This is increasingly common. And the IRS will consider it when you file your home business taxes. Are you more of a weekend dabbler? Are you not putting inconsistent time before and after your “real” job? The IRS might see it as a hobby.
  • Your abilities as a manager: The IRS will also look at your abilities and expertise in the field. Are you are knowledgeable about the issues related to your home business? Do you have the education or experience to show that you are a capable manager? If so, the IRS will be more likely to allow your losses for a little longer.
  • Money invested: Put your money where your mouth is. If the IRS sees that you are interested in making your business succeed, it will be less inclined to view your home business as a hobby.

Bottom Line: Home Business Taxes and Hobbies

When you are operating a home business, you want it to be seen as a business by the IRS. Otherwise, the losses you incur will have a more limited impact on your tax liability. You could become the subject of an IRS audit.

Create a plan to show that you are serious about making your home business work. Invest in home business software to keep track of your money. Your organization, business plan, and your expertise can help convince the IRS that you run a business. This will buy you more time to turn a profit — and still claim deductions.

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