Some taxpayers want to deduct expenses for questionable businesses. As tax accountants, we must determine if they have a business or a hobby. Hobby losses are not deductible. These discussions don’t last long as the taxpayer is often convinced they have a business with deductible expenses. I love the response that "someone" told them they could. The problem is that "someone" is not signing the return. So, when does one have a business?
A business, by definition, is the pursuit of profit. Pursuit does not mean you arrive at your destination. Some businesses lose money for years. So what makes a business a business? Intent of the owner is a lot of it. When a taxpayer says they are trying to make a profit we have to take it at face value. Only their future actions will expose the true intent.
If taxpayers want to show they are pursuing profit, then monitor profit. This means separate books and records and reviewing financial statements periodically. In the early years of a business, it is important to have projections of when profit is expected. IRS Audit Guides usually have some blurb about a businesses showing profit one out of last five years or seven years or something like that. The myth I hear a lot is “if we show a profit this year they won’t audit me”. That is just not true since the illusion of profit is not really profit. The Audit Guides are simply guides, no more. There are other factors to consider.
Other factors: the amount of hours spent in the activity, previous expertise and success, time spent learning the business and honing skills to name a few. How reasonable are the expectations? The amount of pleasure is important. Example: being in the business of bass fishing is a lot more pleasurable than someone in the business of digging ditches. Losses from the business of bass fishing will be scrutinized more than losses from ditch digging. We usually find in the world of sporting events (like fishing), the main source of revenue is from sponsorship. If the bass fisherman isn’t knocking on doors for sponsor money, then how will it ever be profitable?
The best advice I can provide for all businesses: Keep separate books and records (including hours spent), comply with all normal business regulations like issuing W-2 and 1099 Forms and file Sales Tax Returns when necessary. Register with all Federal, State and local agencies as well as obtain proper licensing. Join associations and industry groups to expand your knowledge of the industry. Carry the proper insurance. In the end, it will be the actions of the owners that will determine the nature of the activity. Sometimes it is hard to explain, you just know it when you see it.
The best advice for those trying to turn a weekend hobby into a business: If you don’t reasonably expect to make a profit and can’t reasonably forecast one, forget it, you don’t have a business. If you still think you have a business, then follow the advice above and be prepared to shut it down if you find you can not reach profitability.