My favorite tax writer has done it again — Tony Nitti does an amazing job in this article of explaining the nine factors the IRS takes into consideration when deciding whether an activity is a business or a hobby.
Where I see this come up most frequently is when someone loves a product (or service) — some examples I’ve seen are essential oils, diet supplements, a brand of clothing, or even a coaching method — and they realize that if they become a reseller of that product or service, they get deep discounts on the products. Bam! All of a sudden they have a business, right? Wrong. If the reason they enter into the activity is to get a personal discount on personal products, that’s not a business. There are specific guidelines and definitions about what constitutes a business, and that’s not one of them.
However, if they engage in that same activity in a businesslike manner and with an intent to make a profit, then it is possible that it might be treated as a business and therefore the expenses can be deducted against the income.
I’ll quote the master to explain further, since he does such a good job with it; but ultimately what I want you to do if you’re in this area (or have a friend claiming they can deduct everything related to their part-time hobby) is to just read the article. I promise, it’s both entertaining and educational.
Some excerpts:
Many activities are not entered into “with the intent of making a profit.” And when that happens, the activity is a hobby rather than a business.
The ramifications of being categorized as a hobby are severe: while a business can generate a loss, when you’re conducting a hobby, you may only deduct your expenses to the extent of your income. But here’s the rub: these hobby expenses have historically been deducted as other miscellaneous itemized deductions on Schedule A. That makes a hobby classification particularly painful in 2018, because as part of the Tax Cuts and Jobs Act, there are no more “other miscellaneous itemized deductions.” So you get the idea: from 2017 on, if you’re conducting a hobby, and not a business, you have to include all of the income, but can’t deduct any of the expenses.
The case history surrounding the hobby loss rules extends FAR beyond 2018. There are countless decisions covering everything from horse breeding to rental activities to cattle ranching to motocross racing… a common theme would quickly emerge: if you don’t take your business seriously, then the IRS and the courts won’t either. Thus, it is absolutely imperative that you conduct your activity in a businesslike manner, and a good start would be to do the following:
- have a mission statement,
- maintain a separate bank account,
- keep separate, accurate, books and records,
- use those books and records to manage the business; i.e., if a business line isn’t profitable, perhaps you should consider abandoning it,
- consult with people in the industry to see what has worked for them,
- make efforts to cut costs if losses are continuing to mount.
In sum, it’s not enough to keep a QuickBooks account. You have to show that you’re really trying to generate a profit, and that means you have to actually, you know… use the information contained within those books and records to try and turn a loss into a profit.
Source: The Top Tax Court Cases of 2018: Reunited With The Hobby Loss Rules And It Feels So Good