There are tax implications to consider when turning your hobby into a business. Perhaps you enjoy sewing and would like to open a seamstress business. Or maybe you would like to turn your gardening or blogging skills into an income-producing business.
If your business is profitable over a certain period of time, you likely won’t have any tax problems. But it’s a different story if your new venture consistently generates losses and you claim them on your tax return.
Tax Implications When Turning Your Hobby Into a Business
In general, you can deduct losses for expenses that happened in a bonafide business. But the IRS may categorize your new enterprise as a hobby rather than a business if it does not produce a profit. In this case, you will not be eligible to deduct losses.
On the other hand, if your business is not affected by the hobby loss rules, then allowable expenses are deductible, usually on Schedule C. Even if they exceed income from the allowed business.
Before 2018, deductible hobby expenses could be claimed as miscellaneous itemized deductions subject to a 2% of annual gross income. But since miscellaneous deductions are not allowed from 2018 through 2025, deductible hobby expenses are effectively wiped out for this period.
How to NOT be Classified as a Hobby
There are several ways to avoid the hobby loss rules:
- Operate the venture in such a way as to show that you intend to turn it into a profitable enterprise rather than just a hobby. According to the IRS’s own regulations, the hobby rule will not apply if the circumstances and facts show that you have a profit-making objective.
- Show a profit in at least three out of five consecutive years. For breeding, training, showing or racing horses, the rule is two out of seven years.
But what are the tax implications if you cannot show your intentions to turn your hobby into a business? First, you should operate the venture in a businesslike manner. Secondly, the courts and the IRS will look at the following factors:
- Your expertise in the area
- Whether there’s an expectation that the assets used in the activity will rise in value
- Your history of income or loss in the activity
- How you operate the activity
- Your success in carrying on other activities
- Whether the activity involves elements of personal recreation or pleasure
- The amount of any occasional profits earned
- Your financial status
- The time and effort you put into the venture
Case Illustrates the Issues
In one case, seamstresses operated a sewing shop that made and sold various types of garments. Even though they had a physical space, they didn’t qualify as an activity engaged in for profit according to the courts. The court noted that the partnership had a substantial loss history and paid for personal expenses. Also, the taxpayers kept inaccurate records, had no business plan, earned significant income from other sources and derived personal pleasure from the activity.
Contact us today or visit us for more details about tax implications when turning a hobby into a business. Our tax professionals at The Ray Group can advise you on what to do to avoid tax problems.
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