Avoiding the Hobby Tax Trap

Many questions HBS receives from business owners involve business structures.  Some want to know how sole proprietorships and LLCs differ.  Others want to know the advantages of partnerships, corpotions and S Corpotions.

In upcoming weeks I will share the basic -implications of various business structures.  Before starting, however, a few words of warning for those contemplating the “form” their business will take: Business structures are highly complex.  The choice of structure is often one of the first decisions owners make with regard to their business.  It is also one of the longest-lasting and financially equential.  No article can provide enough information to base such an important decision.  Before committing to a particular structure, study the pros and of each option in light of your long-term business objectives. Then ult with and legal professionals before making a final decision.

Today’s article will discuss the “non-business” business structure – the hobby and the “ tp” it can spring on unsuspecting owners.

New businesses commonly sustain losses in the first few years of opetion – losses which may be deducted on the owner’s .  Unfortunately, businesses that are not opeted in a “business-like” manner run the risk of springing the hobby tp – having the activity declared a hobby by the IRS.  If this hens the IRS may disallow these losses and make all hobby revenue , most related expenses nondeductible, and the owner li for back-es, penalties and interest.

Hobbies receive less favoble treatment than businesses.  All hobby income must be reported on the front of the hobbyist’s income .  This is genelly line 21 (Other Income) unless the hobby involves buying and selling collectibles, which is subject to capital gain rules and reported on Schedule D.  Only collectors can offset sales income by deducting their basis (their investment) in sold collectibles – up to the point of breaking even.  Expenses associated with other hobbies can only be deducted in a special order as itemized deductions on schedule A.  With the exception of certain deductions such as mortgage interest and property es, hobby deductions – whether tding coins, selling makeup, or tding ext produce from the garden – cannot genete a loss.

The IRS defines a hobby as a revenue-geneting activity that lacks a motive.  A “business” activity that lacks a motive is a hobby, not a business.  The IRS will genelly assume an activity is a business if it genetes a three of five ecutive years (this period may be longer for other activities such as horse cing, showing, and breeding).  If the activity genetes losses for three of five years the IRS may review the “facts and circumstances” to determine whether the activity is a for- business or a hobby.  If the activity is reclassified as a hobby, the IRS may add back the losses claimed on s, resulting in back-es, penalties, and interest.

If your business has sustained losses for the past few years you can avoid the hobby tp by making sure the facts and circumstances are on your side.  Be prepared to show the following: 1) Proper licensing, 2) Sepate business bank accounts and credit cards, 3) Payment of all business es, 4) Good accounting records, 5) lic insunce and sepate business phone line, 6) A log showing that substantial time is devoted to the activity, and 7) Documented actions taken to help make the activity .

This will not automatically prove a motive.  It will, however, greatly reduce the odds of the IRS classifying the activity as a hobby and help substantiate that you are entitled to any business losses you have claimed on your income .

In today’s article I have discussed the implications of hobbies.  In the near future I will visit sole proprietorships and partnerships, then on to LLCs, Corpotions and S Corpotions.  If you have questions regarding the ation of your business or need help with any other issue, please feel free to contact our office to ult with a professional.

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