Is your business an active trade or business or a hobby in the eyes of the IRS? This is one area that is constantly being litigated in income tax law. An activity must be engaged in for profit to avoid the hobby loss rules, but each business is viewed on a case-by-case basis and must be able to prove their profit motive to the IRS.
One disadvantage of being considered a hobby instead of an active trade or business is that you will not be able to deduct losses against other income. Hobby expenses are deducted as miscellaneous itemized deductions, up to the amount of hobby income. Miscellaneous itemized deductions are only beneficial as a deduction to the extent that they exceed 2 percent of your adjusted gross income.
There are a variety of areas the tax courts will look at to determine if the business does have a profit motive. A few things they may consider are:
- Is there a legitimate profit motive?
- Are complete and accurate accounting records maintained?
- Does the taxpayer devote substantial time to the activity?
- Does the profit motive outweigh any elements of personal pleasure associated with the activity?
There is a rebuttable presumption that a business is an active business if the business has profit in three out of five consecutive years. An activity involving breeding, showing or racing of horses is presumed to be an active business if it generates of profit for two out of seven years.
Please contact your Rea & Associates advisor to learn more on how your business will be viewed in the eyes of the IRS.
This article was originally published in Illuminations: Facts & Figures from people with a brighter way, a Rea & Associates enewsletter, 3/15/2006.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.