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One of my most important focuses to turn a profit as a small business owner is to take advantage of IRS allowed business tax deductions. Of course, I'm referring to the IRS allowed deductions for business expenses that are ordinary and necessary for running that business. However, what if the IRS does not consider what you are doing a business?
As an attorney, running a small business of my own, I often had clients inquire as to the availability of tax deductions for various enterprises they were undertaking. As an example, one of my clients enjoyed baking and did so frequently. One year, that client had participated in a local baking show where some of the baked goods were sold for profit. At the end of the year, the client inquired as to whether they could deduct expenses related to their baking for the entire year by considering their baking activities a business. In an example like this, the IRS was likely to consider this a hobby and not a business. So how does the IRS make this determination?
The general rule of thumb is that the IRS will consider an activity a business if it is being conducted with a reasonable expectation to turn a profit. In the case of my client, the baker, the great majority of his activity during the year was not being conducted with any expectation of a profit whatsoever. For that particular client, I advised that the IRS would probably consider his baking activities a happy and therefore expenses related to it were not deductible as business expenses.
If you are wondering whether your small business would be considered a business or a hobby, there are various questions you can ask yourself. First, ask yourself if the time and effort that you put into the business activity is intended to turn a profit. Even if you do intend to make some profit, ask yourself if you rely on this income for your living expenses. Doing so makes it more likely the IRS will view your activities as a business.
Another aspect to consider is how the IRS would treat losses if your expenses exceed your revenues. You should ask yourself if the losses are due to factors outside of your control such as starting a business that expects to make a profit in the future.
The IRS will automatically consider your activity as a business if it made a profit during three of the last five years. Of course, the IRS understands that some businesses have good years and bad years and in some years, the expenses may exceed revenues. If your business activity loses money for more than two years in a five-year period, the IRS may inquire as to the specifics of your activities to discern if it is a business activity or, in fact, a hobby.
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