Is your “business” for profit or a hobby? Now, don’t get riled up. I’m not trying to insult you. I’m not talking about what the business does but how you approach the business. Yes, we all want to make money but is that your main factor for starting the business? If it’s not, that is fine. Great businesses have developed from someone’s garage when they found a market for their passion. They became a for-profit business. It doesn’t matter if they are making computers or doilies as long as they treat it as a for profit business. At the same time, there are owners who treat their business as a toy and it goes nowhere. How many restaurants or stores limp on because the owners are having too much fun being in business and not running the business enough. It’s up to you the owner. Oh, yeah, and the IRS too.
First, what is profit? To start, I’ll define “profit” as the money remaining after the entity’s income is offset by the expenses. You open your business with $500 in the checking. As the year goes by, you deposit the business income and write checks for the business expenses. If you have more than $500 on December 31st, you have a profit. The idea is to increase that profit as the business grows. So, what is a hobby? For the IRS, it comes down to the profit motive. A business is to make money and if it’s not making money, the owner changes the business or closes. If not, it’s a hobby. IRS’s “hobby” is not about the actual business but how the business is being run. Is the owner really trying to make money?
The IRS uses a concept of “presumption of profit.” to evaluate a business. Section 183(d) says that if a business makes a profit in 3 of the last 5 years (2 of 7 if horses are involved) it is presumed the business is being carried on for profit and it is not a hobby. But if a business doesn’t met those guidelines it can still be considered for profit? Yes, but it needs to be objectively evaluated. Some factors to consider:
- Does management keeps good books and tracks the results of the business’s activities? Do they try new methods and ideas to bring in more income or reduce expenses?
- How knowable is management about the field and business in general. How are they keeping up with the latest developments?
- How much time and effort is the owner putting into the business? It can be a part time activity but the owner need to regularly working it.
- Has the owner had other businesses before and how successful were they?
- Is this a dry spell for a previously successful business? What is the ratio of profits to losses?
- Does the owner depend on this business for their livelihood?
- Is the recreation/fun element of the business greater for the owner than profit element?
- I also look at what the expenses are. Would there be a profit if there was no depreciation or mileage or Office in Home?
Why the distinction? I can think of 2 reasons. The first is taxes. Income and losses from a hobby are handled differently than the income and losses from a business. Let’s look at 2 sole proprietors- very simplified of course. But remember this could be 2 partnerships, LLCs or S- Corps.
Business “P” will report its activities on a Schedule C or F on its owner’s Form 1040. All income, expenses and depreciation of the business will be reported and a profit or loss will result. The profit or loss will then carry to the front page of the 1040 and add to or decrease the owner’s other income. If there is a profit, it is also carried to Schedule SE and the self-employment tax is calculated and added to the owner’s other taxes. An adjustment for half of the self-employment tax is also carried to the first page of the 1040 and lessens the total income.
Business “H” doesn’t use a Schedule C or F. The income is reported on the “other income” line of the owner’s 1040. The only expense that can be taken off here is the cost of goods to manufacture the items being sold. (On the Sch. C, this would be the gross profit.) All the rest of Business “H’s” expenses have to be reported on the Schedule A and are limited to the remaining income. Business “H” can’t use a loss to offset other income. The expenses also have to be divided into 3 classes. The first class, are expenses which anyone can deduct on the Sch. A; mortgage interest and real estate taxes are the most common. The second class of expenses includes anything that doesn’t change the basis of the business assets. The final class is depreciation. The big catch is that both of these classes are reported a Misc. Deductions and are reduced by 2% of the income from the 1040 return. Then, the total of all the itemized deductions from the Sch. A has to be higher than the standard deduction to actually do any good. So it is possible for Business “H’s” expenses to be un-usable in reducing the tax on the income. Now the good news; Business “H” does not have to pay self-employment on any profits from their activities.
Now I’m sure someone has decided to make the decision between a hobby or for profit based on how their year went. You’re a hobby in a year where you make money and avoid the SE tax and for profit when you have a loss to reduce your other income. Not a good idea. Can you say audit?
The other reason to think about the distinction between for profit and hobby has to do with how you approach your business and what that shows to others. There is nothing wrong with a business being considered a hobby for tax purposes, if that is what the owner wants. But if the IRS is treating you like a hobby, you can’t expect a bank, vendor or investor to treat you like a business. They don’t have to see your tax return to know if you are running the business for profit. They will look the same types of information as the IRS and come up with the same conclusion. Your decision not to be for profit will be transmitted to customers and employees by the way you approach the business hobby. The business may not work or you may have bad years. Businesses close all the time. Failure is okay. But don’t create the failure because you don’t want to work the business.