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        Taxation 101: Hobby or Business?

        © 2014 Elena Fawkner

        For many of us it's tax time again.  For others, tax time is
        just around the corner.  So, how was business this year?  Did
        you make a profit?  If your business is very new, most likely
        you made a loss.  Oh well, at least you can write it off, right?
        Well ... maybe.  Whether you can write off your business losses
        depends on whether your business really is a business or a
        hobby.  "Well, of course it's a business!", I hear you say.  "I
        don't put myself through this for the fun of it!".

        In this article we look, first of all, at the things you need to be
        doing in your business to make it very clear to the IRS that
        you are, indeed, running a business and not merely indulging
        in a hobby.  The reason this is so important is that although you
        have to declare and therefore pay tax on the income you make
        from a hobby, you can't write off your losses and may not even
        be able to deduct your expenses at all.  Secondly, we'll take
        a look at some of the common business tax deductions you
        should be thinking about in the context of your business.  Even
        if you didn't have your act together last year in terms of keeping
        records and receipts for all this stuff, at least you can get your
        house in order for when this year's tax return is due.

        HOBBY vs. BUSINESS

        The crucial distinction between a hobby and a business is
        whether you engage in the activity with a profit motive.  Now,
        by profit motive, we don't mean that "gee, it's really great
        that I can make money doing something I love", we mean "I'm
        doing this with the intention of making a profit and if I can't make
        a profit doing this then I'll find something else to do that will make
        me a profit".  The difference is one of motive.  In the former, the
        motive for the activity was the doing - the enjoyment inherent
        in the activity itself.  Making money was an incidental, albeit
        most welcome, benefit.  In the latter, the motive for the activity
        was to make a profit.  That's not to say that you can't enjoy
        what you choose to do to make that profit, it's just that your
        primary objective must be to make a profit such that if this
        venture is inherently unprofitable, you would presumably choose
        not to pursue it.  With a hobby, on the other hand, even if the
        activity was inherently unprofitable, it is something you would
        choose to do anyway.

        OK, so much for your own subjective intentions.  How does the
        IRS decide whether you truly have a profit motive?  There are
        two ways it goes about it.  The first is an objective test.  Quite
        simply, the IRS will look at your tax returns for the last 5 years
        and if you made a profit during at least 3 of those years, you
        will satisfy the profit-motive test.  If you don't meet this test or
        if your business is new and you haven't filed 5 tax returns, then
        the IRS will apply a subjective standard.  In applying the
        subjective standard, the IRS auditor considers and weighs
        several factors, including:

        => Businesslike Manner of Carrying On Activity

        The IRS will look at how you carry on your activity.  Do you keep
        a good set of books and records or do you chuck receipts into
        a battered shoebox?  Do you have separate bank accounts for
        your business?  Do you invest in advertising, marketing and
        promotion?

        => Time and Effort Invested

        Is your business a sideline or something you pursue more or
        less full-time?  Obviously if you devote substantially all of your
        available time to the activity, the more likely it is that you have
        a profit motive since that is your primary source of income.
        Things can be trickier if you work full-time and your business
        is something you pursue on the side.  Just be sure you can
        demonstrate an ability to devote substantial time and effort
        to your business.  Unlike a hobby, a real business in which
        you have a profit motive demands time and effort.  It's NOT
        something you just don't get around to this week because
        "things came up".  With a hobby you can do that.  With a
        business you can't.

        => Track Record of Profit-Making Ventures

        If you have a history of involvement in profit-making activities
        in the past, this will be relevant to your ability to make a
        profit in your current venture.  Conversely, if you have no
        track record at all of involvement in profit-motivated
        pursuits, the IRS is going to be looking for evidence that
        you know what you're about and have sufficient experience
        and expertise to turn your activity into a profitable
        sideline.

        => Nature of Losses

        The nature of the losses you claim will also be a relevant
        consideration.  If you're a start-up, substantial first year
        losses are to be expected.  After that, however, you should
        be demonstrating a shift towards profitability.  Your second
        year may still show a loss but it should be a smaller one
        that your first and your third should be smaller again than
        that, and so on.

        => Changes in Operations

        If you continue doing things the same way, day in day out
        even when they're clearly not working to make you a profit,
        that's a strong indication that you're engaging in a hobby
        and that you don't have a profit motive.  On the other hand,
        if you can demonstrate changes in operations to attempt
        to fix what isn't working for you, this will lean towards a
        profit motive.

        => Profit Patterns

        The IRS will also be looking for profits in some years, even
        if losses occur in others.  A pattern of small profits and large
        losses every year, year in, year out will raise suspicion.

        This is just a sampling of the types of factors the IRS will
        give weight to in adjudging whether your "business" is truly
        a business or a hobby.  For more information, visit the IRS
        website at http://www.irs.gov.


        COMMON DEDUCTIONS

        OK, now that we all have healthy profit motives and are
        therefore running serious businesses here, let's finish up with
        a quick look at some of the common business deductions
        for home-based businesses:

        => Home office deduction.  For a complete article on this
        deduction, read "Taxing Times ... The Home Office Deduction" at
        http://www.ahbbo/homeofficetax.html .

        => First year expense deduction.  You can deduct up to $20,000
        worth of equipment as a current expense during your first year of
        business with this deduction.  Otherwise, you would have to
        deduct it over a period of years depending on the depreciation
        schedules for the assets concerned.

        => Auto expenses.  If you use your car for business purposes,
        you can claim mileage or depreciation.  The mileage method allows
        you to  deduct the amount per mile the IRS allows for the particular
        year.  The depreciation method allows you to take a depreciation
        deduction on the cost of your car and add to that all costs and
        expenses associated with running your car including maintenance.

        => Health insurance payments (proportion).

        => Business insurance premiums.

        => Contributions to retirement plans.

        => Continuing education expenses related to your business.

        => Gifts valued at up to $25 per person per year.

        => Internet and email services - ISP, webhosting etc..

        => Interest on business credit.

        => Entertainment - 50% of ordinary and necessary business
        expenses for entertaining clients, employees, etc..

        => Advertising, marketing and promotion expenses.

        => Membership dues for professional associations.

        => Subscription costs for professional and trade publications.

        => Local travel expenses e.g. taxis, trains etc..

        => Business travel expenses - airfare, accommodation, meals,
        entertainment etc..

        => Postage.

        => Furniture and equipment.

        => Business cards, stationery and office supplies.

        => Parking fees.

        => Bank fees on business accounts.

        For more detailed treatment of each of these deductions, as
        well as many others, visit the IRS website at http://www.irs.gov.

        Tax time is no fun for any of us but there is no reason to
        make it any harder than it has to be.  If you keep putting off
        getting your tax return prepared because you just can't face the
        thought of going through that shoebox at the back of your
        closet to organize your receipts, make a vow that this is the
        last year you will do this to yourself.  It's still early enough in
        the year to get your act together and by this time next year
        you could be focusing on your business rather than stressing
        out about something as unnecessary as tax-time hassles.

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        ** Reprinting of this article is welcome! **
        This article may be freely reproduced provided that: (1) you
        include the following resource box; and (2) you only mail to a
        100% opt-in list.

        Here's the resource box to use if reprinting this article:

        Elena Fawkner is editor of Home-Based Business Online. Best business ideas and opportunities for your home-based or online business.

        Copyright 1998-2017, AHBBO.com. All rights are reserved. Tuesday, 26-Jan-2021 03:13:37 CST


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