You’ve probably heard the sage advice that “if you find a job you love, then you’ll never work a day in your life.” However, turning your hobby into a cool part-time business could trigger something you didn’t expect and certainly don’t want: an IRS audit.
A Tale of Two Perspectives
At issue is the fact that the IRS can view your activity as a hobby, whereas you view it as a business. Why does this matter? Because if the IRS’s view prevails, then you aren’t entitled to deduct any business losses. And if you try and claim some on your tax return — just as you would with any legitimate business losses — you could raise some red flags and be targeted for an audit.
Let’s say that you were born with a proverbial Green Thumb, and your gardening wizardry has inspired you to grow orchids in your backyard greenhouse and sell them part-time. Of course, let’s also take it as a given that you dutifully report all sales income on your tax return.
However, just like any other business owner, you incur some costs as well — such as buying soil, fertilizer, maintaining your greenhouse, perhaps running a website to showcase and sell your flowers, and so on. These are real costs of doing business, and as such, you list them as legitimate expenses that offset your overall tax bill.
What’s the problem with this? Well, the IRS may not agree that you are, in fact, running a real business if you’ve been racking up these kinds of losses for a few years. Instead, they may assert that it’s a hobby. If so (and provided that you don’t challenge this and win in Federal Tax Court), at best your deductions will be denied, and at worst you’ll be flagged for an audit.
Hobby or Business?
Internal Revenue Code 183 (known as the “hobby loss rules”) lists nine factors that the IRS uses to determine whether an action is a business (i.e. an “activity for profit”) or a hobby:
- If the taxpayer conducts the activities in a business-like manner (e.g. maintaining separate business bank accounts, keeping records and books, etc.).
- The taxpayer’s level of expertise, and if she or he is qualified to generate profit from performing the activity.
- The time and effort invested by the taxpayer in carrying out the activity.
- The expectation by the taxpayer that the assets used in the activity (if applicable) could rise in value.
- The success of the taxpayer in carrying on similar or dissimilar activities.
- The taxpayer’s history of income or losses performing (this relates to the gardening example discussed above).
- The amount of occasional profits.
- The financial status of the taxpayer, and whether she or he has other income sources.
- If the activity has elements of personal pleasure or recreation (the more personal elements, the more likely it is to be viewed as a hobby).
What You Should Do
There’s nothing wrong with turning your hobby into a cool part-time business. In fact, it’s a great idea and could lead to a career path that is both financially lucrative and personally satisfying. However, it’s vital that you plan things properly, and this includes ensuring that you proactively get advice from a tax lawyer. In the big picture, it’s a very small price to pay for the peace of mind that comes from knowing that if the IRS comes calling, you won’t break a sweat and your cool business won’t skip a beat — because you’ll be 100 percent in compliance.