When does a hobby become a business? It sounds like a simple question to answer. But, that’s not always the case. The IRS has rules for what qualifies as a business, and your entrepreneurial idea might not be making the cut.
Why should you know the difference between hobby and business?
Whether your venture is a hobby or a business affects your tax liability. If the IRS declares it’s a hobby, you can’t deduct business losses and expenses on your tax return. You can only deduct your hobby expenses up to the amount of income you earn.
Let’s say you want to start a T-shirt printing business. You spend $1,000 on a new screen printing press. In your first year, you only make $50 in sales. The IRS audits you and decides your company is a hobby. Hobby loss rules dictate that you can only deduct up to $50 you earned.
If you deduct business expenses when you’re not a real company, you can get some heavy penalties. Treating a hobby tax deduction as a business tax deduction on your tax return can potentially put a heavy burden on your finances. You could end up getting IRS penalties and have to pay back the deducted amounts.
So, is your “business” a hobby, or is it a real business?
That is a question that all aspiring entrepreneurs need to answer objectively. It’s one thing to start a business that is really a hobby. But, starting a real business is a whole other beast!
Here’s what I mean when I talk about starting a real business. After engineering school, I had a full-time job at a big company. I was on the business’s fast track, my raises were frequent, and my career was in great shape.
Then, I decided to toss it all away. I quit my job to start my own business. I had very little money saved. On top of bills, car payments, and a mortgage, I didn’t have a safety net.
Basically, the pressure was on. Nobody was going to bail me out. It was a one-way ticket, and there was no turning back. For me, this was the real deal.
You might have a similar story about your startup. But, are you sure your idea is a business and not a hobby in the eyes of the IRS?
When does a hobby become a business?
Unfortunately, there are no concrete rules for determining if you operate a hobby or business. The IRS does say that a business must actively be trying to make a profit. To prove your startup is a business, you need to be able to show that you are making an effort to turn a profit.
Proving your business’s intentions is not always simple. The most obvious way to meet the IRS’s requirements for a business is actually to make a profit.
Easier said than done, right? The first few years are the hardest for small businesses. In fact, over half of new businesses fail within the first five years.
When my partner and I started our business, we didn’t have much. But, we did have a couple of customers willing to pay us. Over time, some of our first buyers became repeat customers.
Over the first year, we worked long hours. Our take-home pay ended up being about $2 per hour. We were scratching to stay in business, and we were flat broke. But, since we had some sales with a few bucks coming in, we kept going.
Usually, you won’t be considered a hobby if you make a profit for three out of the first five years you are in business. The amount you make can be small. If you can show the IRS you made a couple of dollars off your startup, you should be OK.
Proving you’re a real business
Maybe you didn’t bring in any money during the first two years you were in business. It should be fine for you to declare business losses on your tax return. But, any longer than two years without profits could raise a red flag for an IRS audit. If you haven’t turned a profit in three or more years, the IRS might say your business is a hobby.
Making money alone isn’t enough for the IRS to consider you a business. You need to proactively demonstrate that your business is valid.
One of the most important steps you can take is to record accurate and complete accounting books. The more types of business records you keep, the better. You need to be able to prove your business's income and expenses.
Also, comply with federal, state, and local business laws. Don’t cut corners when it comes to keeping your business legal. Make sure you have all the permits, insurances, and identification numbers you need.
If you’re going to show the IRS you are a legitimate company, you have to act li
ke one. You can do this by marketing your business. Most businesses use some form of marketing, from free digital marketing for small business to a million dollar campaign. You don’t need to pour money into huge marketing efforts. But, at least have a business card and some advertisements in your community.
If you are running a business and not a hobby, you should be able to show proof to the IRS. Growing into a revenue-generating company is a gradual process. You need to set yourself up for success early to start earning a steady income.
In our first year, my partner and I each took home about $12,000. The second year, we each took home zero dollars. We lived on fumes, credit cards, and our equity lines of credit.
The third year, we again took home right around $12,000. Finally, at the end of year number four, our earned income was $40,000.
As we got through the early years, we increasingly brought in more profits. But, growing a company takes time. Make sure you launch your startup as a legitimate business from the start. Eventually, the IRS will see that you are a real business, not a hobby.