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Turning a Hobby into a Small Business

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Aug 03

Small business makes custom fishing luresThese lures are spectacular! You should start a business.”

Rick’s friend was so impressed with his custom fishing lures that he uttered those indelible words.  The seed was planted and Rick began considering the possibility of starting an online fishing lure business the very same day.  While many people have an outside passion or hobby that can be turned into a profitable enterprise, the real question is should they take that entrepreneurial leap?

Before Rick takes those fishing lures and starts selling them online, he needs to consider carefully how he will transition his enthusiasm for fly fishing into a full-fledged business venture.  The Internal Revenue Service has many criteria for defining the difference between a business and a hobby.  While Rick’s friend paid him a great compliment, without proper due diligence he may be stretching his hobby and calling it a business when it’s really not.

Rick decides to meet with a fellow angler who happens to be a small business  accountant. The accountant tells Rick that if his tax filings show income or loss from a hobby, it may warrant further investigation by the IRS to decide if the hobby is actually a business.  An IRS auditor could also review his tax returns and perform two specific tests to make a determination.

The first test is the profit test which demands that if the enterprise has shown a profit for three out of the five years that it be treated as a business.  If the hobby has produced income meeting this criterion, it may be viewed as a business by the IRS.  Rick can get a jump on the IRS by applying the profit test and the provisions of the second test—the facts and circumstances test—to his small business venture.

Much of this process can be avoided, if Rick establishes his new business as a formal entity (such as a limited liability corporation), creates separate bank accounts, and maintains a strict line between personal and business expenses.

The second test used by the IRS is the facts and circumstance test; performed by examining the following areas:

1)      Does the hobby function in a business-like manner?  Have you developed a short-term and long-term business plan?  Does the business plan include investing in advertising and marketing, or capital purchases?  Does your hobby have a good set of financial books?  If Rick can answer a resounding ‘yes’ then he is on his way to “business” status.

2)      What is the time and effort put into the activity and does it indicate that you intend to make the venture profitable?  If Rick only spends 10 hours a week on the venture but has a full-time job elsewhere, then it may be considered a hobby.  If he spends a majority of his time each week working on the enterprise and showing profit, the IRS is more likely to consider it a business.

3)      Do you depend on income from the activity for your livelihood?  Again, if Rick is only working 10 hours per week on the enterprise, odds are that he doesn’t depend on the income generated to sustain his family’s lifestyle.  If all or a substantial portion of his annual income is derived from the venture, it’s probably a business.

4)      Are your business losses due to circumstances beyond your control or are they normal in the start-up phase of the business?  Can Rick demonstrate how he plans to move from loss to profit and show a return on his investment?  If he can show a business plan and profit and loss projections for the venture then the answer is probably; yes, he’s running a business.

5)      Do you adjust your methods of operation in an attempt to improve profitability? Can Rick directly relate hiring of employees, streamlining production or distribution, or the establishment of an online storefront to sell his product or service?  If yes, then it is most likely a business.

6)      Do you or your advisors have the knowledge needed to carry on the activity as a successful business?  If Rick is an expert in fishing lures and he’s designing beautiful one-of-a-kind custom settings and selling them at a profit, the IRS will consider his fishing lures venture a business and not just a fun hobby.  Remember that the profit reported on Schedule C, is subject to Self-Employment Tax.

7)      Were you successful in generating a profit from similar enterprises in the past?  If Rick owned other businesses in same field previously, an auditor may feel that both his experience and expertise in the new venture are for profitable motives as well.

8)      Can you expect to make a future profit from the appreciation of the assets used in the activity?  This point has been successfully argued but may require the determination (and money) to take the matter to court.  A pattern of small profits with larger losses will also raise a red flag with the IRS.

9)      Is there an element of personal pleasure in the activity?  Everyone should have a job they enjoy but if Rick finds that he’s running rafting trips up and down the Colorado River (even amidst high gasoline prices) regardless of the profit or passenger manifest and does nothing to improve the profit potential, then it’s most likely a hobby and cannot be considered a part of his fly-fishing business.

Now that Rick has reached the end of the IRS questionnaire and concluded that he will be running a business, he can take the time now to prepare for tax season.  He’ll need to gather together purchase and sales receipts, travel expenses and utilities and start formulating a business plan and profit and loss statements.  The good news is that now that Rick’s hobby is officially a business, he can qualify for additional expenses and deductions that his hobby could not utilize.

PASBA member accountants bring the collective resources of a nationwide network of Certified Public Accountants, Public Accountants,  Enrolled Agents and other practitioners available to answer your tax and financial questions and streamline your business accounting, bookkeeping, and payroll operations. To find a trusted accountant in your area, visit www.SmallBizAccountants.com.

Please be advised that, based on current IRS rules and standards, any advice contained herein is not intended to be used, nor can it be used, for the avoidance of any tax penalty that the IRS may assess related to this matter. Any information contained in this article, whether viewed or subsequently printed, cannot be relied upon as qualified tax and accounting advice.  Any information contained in this article does not fall under the guidelines of IRS Circular 230.

Copyright Information 2011 Professional Association of Small Business Accountants

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