For-profit business vs. not-for-profit hobby

Many people who run unprofitable small businesses run up against a tax regulation that can have some unanticipated (and possibly severe!) negative consequences.

In general, the IRS distinguishes between activities that it considers to be engaged in for profit (a “business”) versus activities not engaged in for profit (“hobbies”). The tax rules for businesses and hobbies are not the same.

Taxation of businesses is of course very complex, but as a general rule, all business income is taxable, net of any necessary and ordinary expenses. Taxation of hobbies is far stricter: like a business, all income from a hobby is taxable, but you’re not allowed to deduct most (or, as of 2018, any) of your related expenses, even if they meet the “necessary and ordinary” rule. So if the IRS audits your tax return and decides that your “business” is actually a hobby, then it’s going to disallow some or all of the expense deductions you’ve claimed. If they apply this ruling to several years’ worth of tax returns, the tax hit can be huge.

How does the IRS determine whether an activity is a business vs a hobby? It’s not black and white. There are guidelines which can be found on the IRS website here.

If there’s any question whether your business qualifies as such for tax purposes, give that list a look! And then email me if you have questions.

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