by Kelley Keller | Featured Contributor
Did you know that the IRS views hobbies as very different things than businesses? In fact, if you make a mistake when you file your taxes or claim a loss from your “business” activity for too many years, you could get into a lot of expensive trouble.
For example, you can’t deduct expenses from your tax return or claim losses related to that activity to offset your other income if you have a hobby. That’s why it’s critical that you determine if you have a hobby or business right now.
Some of the things that flag your “business” as a hobby probably seem quite subjective. For example, the IRS will look for signs that you’re pursuing an activity as a business with a goal to make money. If your activities have significant elements of personal pleasure or recreation that consistently generate losses, then it’s unlikely that the IRS will view that activity as a business.
The IRS also uses some more objective tests to determine if you have a hobby or business: the 3-of-5 Rule and the 8 questions.
The 3-of-5 Rule
The 3-of-5 Rule is very simple. If you’ve haven’t earned an income from your activity in any three of the last five years, then it’s unlikely that you have a business. You probably have a hobby.
The 8 Questions
The 3-of-5 Rule is simple, but it’s not perfect. The IRS determines if you have a hobby or business by asking eight specific questions. Here they are so you can ask them to yourself:
- Does the time and effort put into the activity indicate you have an intention to make a profit?
- Do you depend on the income you make from the activity?
- If there are losses, are they due to circumstances beyond your control or did they occur in the startup phase of the business?
- Have you changed any methods of operation to improve your profitability?
- Do you or your advisors have the knowledge needed to carry on the activity as a successful business?
- Have you made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Can you expect to make a profit in the future from the appreciation of assets used in the activity?
If you can answer yes to these questions, then the IRS will likely determine that you have a business, not a hobby.
How to Show the IRS You Have a Business, Not a Hobby
If you have a business, not a hobby, then the first step to make it obvious to the IRS is to keep accurate books and completely separate your personal and business finances. Set up separate bank accounts and formally form your business as a limited liability company or a corporation. In other words, become a business.
Second, you need to develop plans and make discernible efforts to increase sales and profits. And third, consult with legal, finance, and tax experts to ensure you’re doing everything correctly.
Remember, if you’re activity doesn’t generate a profit and probably won’t generate a profit in the near future, it’s probably a hobby, not a business!
Kelley Keller, Esq. is President of The Keller Law Firm and a 20-year veteran of the intellectual property law field. As an intellectual property attorney, she has deep experience helping businesses of all sizes identify, manage, and protect their trademarks, copyrights, patents, and trade secrets, including many household brands like Toyota, Disney, and Verizon, which she worked with during her tenure at two of the largest IP law firms in Washington, D.C. Kelley also offers education to small business owners, creative and coaching professionals, digital entrepreneurs, and established companies about starting, building, and growing a Rock Solid Business on an strong foundation through her website KelleyKeller.com.
Kelley’s personable nature and ability to explain complex legal issues in simple terms set her apart from most attorneys. She is relentless in helping businesses, their owners, and their families mitigate risks and open the doors to new opportunities.