It can’t be just a hobby

guest commentary by David Potts

Pain causes many people to visit a certified public accountant. Pain caused by realizing that part of their income is taxed at a median combined Federal and state income rate of 32% and up to 42% for higher income individuals.

Add another 7.65% for Social Security taxes if you have earned (sweat of the brow) income and haven’t reached your annual limit. Taxes paid to a government perceived as arrogant, believing they know a better way to spend your money than you. Or the pain could be because the person may not have enough money to pay their bills and they are considering starting a home-based business to supplement their income. Whatever the reason, their circumstances are causing them to consider starting a business “on the side.”

There are tax advantages to owning and operating a business. Individuals who are employed and receive a W-2 at the end of January each year are limited in what they can deduct to reduce their taxable income. They have a few deductions from gross income (e.g. individual retirement account contributions) and a few categories of itemized deductions (e.g. mortgage interest expense) to choose from. If they do have business expenses related to their work or their profession, these expenses can be deducted as an itemized deduction but only after the aggregate total exceeds 2% of their adjusted gross income. These work related expenses can be further limited, at times, by the alternative minimum tax.

On the other hand, individuals who own and operate a business get to deduct all of their business expenses including the business portion of their automobiles, travel, computers, cell phones, etc. So many people want to start a business to reduce their income taxes. But there’s the catch. These expenses must be business expenses.

More than once a year someone will ask me “will a farm save me income taxes?” Most of the time when they ask this question it is not because they have a great interest in farming. Their interest is lowering their taxable income. My standard answer is to their question is “possibly, if you’re willing to do what it takes to comply with the Internal Revenue Code.” My answer is the same for writers, photographers, part-time pilots, crafts people, race car drivers, tournament fisherman, race horse breeders, network marketers, and any other activity the IRS considers suspicious as to whether it is really a business or a personal hobby.

By definition the purpose of the business is to make a profit. A hobby’s purpose isn’t related to making a profit. The Internal Revenue Code allows a business to deduct ordinary and necessary business expenses in an attempt to make a profit even when money is lost.

The requirement isn’t that a business makes a profit, but that it intends to make a profit. Intent can be a hard thing to prove or disprove. So years ago Congress added a section to the Internal Revenue Code, section 183, titled “Activities Not Engaged in For Profit.” This code section says that if a business is profitable in three out of five years there is a presumption that the activity is engaged in for profit. (Horse racing gets a break. They only have to make money in two out of seven years.)

Many people believe that if they have a side business and can’t make a profit in three out of five years, then the losses are not deductible. That’s not what the code section says. If you have a business and it loses money for 10 straight years the losses are deductible for each and every year. (Think Amazon). What happens is the burden of proof that a profit motive exists is now your burden.

The IRS will look at nine factors described in the regulations for section 183 to help determine whether they believe there is a profit motive in operating your enterprise thereby allowing all your deductions as business deductions in loss years. These factors are: how you run the activity; your expertise in the business activity; the time and effort you expend in the business; whether there is an expectation that the assets used in the activity will rise in value; your success in carrying on other similar or dissimilar activities; your history of income or loss in the activity; the amount of occasional profits, if any, that are earned; your financial status; and whether the activity involves elements of personal pleasure or recreation. No single factor controls and other factors can be considered when determining a profit motive.

So yes, operating a farm can save you income taxes. So can any activity that you engage in for profit … if you lose money. However if you make money it will increase your income taxes.

A lot of people who operate small businesses on the side are somewhat tentative to deduct their losses. They have heard about the “hobby loss” rules and they believe that since their business isn’t big the IRS won’t consider their business activity a business. Other people won’t deduct all their expenses so they can show a profit in three out of five years.

Here’s my opinion. If in addition to working for somebody else you try to make money with a side business of your own, if you have losses, take your losses and reduce your income taxes. It’s what the law allows. Just don’t be lazy. Operate your “side” business as a business. Get familiar with the factors the IRS will use to analyze your business activity. Use these factors as a basis to document your profit motive. And if you’re audited, don’t be afraid of the IRS. You complied with the law.

About Potts
David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, business valuation and business advisory services. He is a Fort Smith native and a graduate of the University of Arkansas. You can follow more of his thoughts at ThePottsReport.com. Although every effort is made to provide you accurate and timely tax information, it is general in nature and not specific to your facts and circumstances. Consult a qualified tax professional to discuss your particular case.

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