Is Your Business a 'Real' Business... or Just a Hobby?
Post #47: Checklist these IRS rules to avoid an audit.
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Did you know…?
“Sole proprietors reporting at least $100,000 of gross receipts on Schedule C and cash-intensive businesses (taxis, car washes, bars, hair salons, restaurants and the like) have a higher audit risk. Ditto for business owners who report substantial losses on Schedule C, especially if those losses can offset in whole or in part other income reported on the return, such as wages or investment income.” (source)
In this newsletter, I’ll help you determine whether your business qualifies as a business by IRS standards, or if it’s just a hobby, and how to avoid getting audited.
Distinguishing between a hobby and a business is essential for tax purposes, as the IRS treats income and expenses from each differently.
This overview will help you to ensure compliance with tax regulations and avoid an audit, tax penalties, or other avoidable troubles.
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Q: Are you operating a business, or just deducting expenses from your hobby?
This is the big question that could help you save a ton of money as the proprietor of a real business… or land you in trouble with the IRS for deducting expenses related to a hobby.
Let’s cover how to differentiate the two scenarios and make sure that you are not going to get into trouble with the IRS.
Basic Requirements to Be Considered a Business
The IRS evaluates several factors to determine if an activity is a business or a hobby.
Ask yourself these questions:
Profit Motive: Is there a genuine intention to make a profit?
Effort and Time Investment: Are significant time and effort dedicated to the activity?
Dependence on Income: Is income from the activity relied upon for livelihood?
Profitability History: Has the activity been profitable in some years, and what are the future profit prospects?
Expertise and Methods: Do you (the owner) possess the necessary knowledge to conduct business, and are business-like methods employed?
Financial Status: Are there elements of personal pleasure or recreation involved?
No single factor is decisive.
If you said YES to all of these questions, you are probably in a good spot to call your business a “business”.
If you answered NO to some of these questions, you may have more work to do.
👇 Keep reading to learn how to close some of the gaps. 👇
8 Tips to Prove Your Activity Is a ‘Business’
If you ever find yourself in a situation where you need to provide evidence (such as when you are being audited by the IRS), or if you want to just be sure to check all of the boxes to avoid an audit, this checklist should get you there.
I’ve added links to articles that will help you with this effort.
(1) Get Registered as a Business
Whether you are a Sole Proprietor, an LLC, or an S-Corp, registering your business with the local Secretary of State and the IRS (for S-Corp election) can really help with compliance.
Keep in mind that forming an LLC or S-Corp does not automatically establish an activity as a business. The IRS examines the entity's operations and profit motive. If these are lacking, the entity may still be deemed a hobby, affecting the deductibility of certain expenses.
(2) Maintain Detailed Financial Records
Keep thorough records of income and expenses. Using dedicated business accounting software can help you get organized and track financial activity. Also, be sure to keep personal and business expenses separate with business banking account(s).
(3) Save Your Business Expense Receipts
Whether you keep receipts in a shoebox, an organized file cabinet system, or digitized in the cloud, proof of purchase for business expenses can really help.
(4) Stay (or Get) Organized
Searching for paperwork can be infuriating and contribute to non-compliance if you can’t find important documents. Set up a digital document storage system to avoid losing paper that will help you prove your status.
(5) Develop a Business Plan
Capture your vision, mission, and goals, and capture strategies for profitability and growth. Back of the napkin ideation is a good place to start, but a written business plan is better.
(6) Focus on Profitability
Every business owner wants to be profitable, but sometimes it doesn’t work out as you expected. Keep your expenses below your income, analyze the work that you are doing to build up your revenues, and keep pushing for profitability to demonstrate a profit-driven intent.
(7) Keep a Journal or Calendar
Many business owners maintain a journal or calendar to track client sessions, sales meetings, business travel, marketing campaigns, and other significant business-related events to demonstrate that effort is being made to generate revenues.
Event tracking can also help with proving that a business expense is a legitimate deduction.
At the very least, make sure that you are capturing expenses and income.
(8) Stay Informed
Regularly review IRS guidelines and consult professionals to ensure compliance. And, be sure to watch out for Tax Scams that could put you in an awkward predicament.
🚨 IRS Red Flags Indicating a Hobby 🚨
When your business activity is not in alignment with expectations of a business, there are certain tell-tales that could lead to disqualification.
These activities are typical “red flags”:
Consistent Losses: Multiple years of losses, especially if offsetting other income.
Lack of Profit Motive: Minimal efforts to achieve profitability.
Personal Enjoyment: Activities that appear primarily recreational.
Inadequate Record-keeping: Poor documentation of income and expenses.
Such indicators can trigger audits and potential reclassification of the activity.
Additional References to Help Differentiate
Here’s how to tell the difference between a hobby and a business for tax purposes
Hobby or business: What people need to know if they have a side hustle
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Have questions about whether your business is really a business or just a hobby? Drop them in the comments.