You’ve loved dogs all your life, so you start a dog breeding and training business. Turning your hobby into a company can provide tax benefits if you do it right. But it can create a significant tax headache if you do it wrong.
One of the main benefits of turning your hobby into a business is deducting all your qualified business expenses, even if it results in a loss. However, if you don’t correctly transition your hobby into a business in the eyes of the IRS, you could be waving a red flag that reads, Audit Me! So why not make your business activity bulletproof! The agency uses several criteria to distinguish whether an activity is a hobby or a business. Here is what you need to know:
The business-versus-hobby test
|You have a reasonable expectation of making a profit.||Profit Motive||You may sell occasionally, but making money is not your main goal.
|You invest significant personal time and effort. You depend on the resulting income.||Effort and Income||It’s something you do in your free time; you make the bulk of your money elsewhere.
|Your expenses are ordinary and necessary to run your business.||Reasonable Expenses||Your expenses are driven by your personal preferences and not strictly necessary.
|You have a track record in this industry, and/or a history of making profits.||Background|| You don’t have professional training in the field and have rarely or never turned a profit.
|You have multiple customers or professional clients.||Customers||You have few customers, mainly relatives and friends.
|You keep professional records, including a separate checkbook and balance sheet; you have business cards, stationery and a branded business website.||Professional||You don’t keep strict professional records of your activities; you don’t have a formal business website or business cards.|
As you can see, a degree of interpretation is involved in reviewing any activity. So, if your dog breeding business (or any other activity) falls under any of the hobby categories on the right side of the chart, consider what you can do to meet the business-like criteria on the left side. The more your activity resembles the left side; the less likely the IRS will challenge you. And to remove any doubt, your best defense is making some money!