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Gregory S. DuPont May 17, 2019

Many people dream of turning their passionate pursuit into a money-making venture. Creating a successful and profitable business is seldom easy, but the Federal government offers tax incentives to business owners that could make converting an avocation into a business start-up an effective part of your overall tax planning strategy. If you are thinking about turning your hobby into a business, you would need to realistically appraise your chances of building a profitable enterprise before you declare yourself a business owner.

Because of the tax breaks associated with business ownership, the Internal Revenue Service (IRS) requires filers to follow certain guidelines before claiming on their tax return that their hobby is, in fact, a business. According to the IRS, the “incorrect deduction” of hobby expenses accounts for as much as $30 billion per year in unpaid taxes, and therefore taxpayers are cautioned against claiming tax breaks for activities that do not meet the IRS definition of a business.

The IRS requires evidence that the amount of time and effort you are putting into the activity indicates an intention to make a profit. You may also need to show that you earned a profit from conducting similar activities in the past, and that you or your advisors have the knowledge necessary to carry on the activity as a successful business. While many start-ups incur losses in the early stages, the IRS may require you to demonstrate that losses are due to circumstances beyond your control, as well as provide evidence of a willingness to change your methods of operation to improve profitability. For your activities to qualify for tax purposes as a for-profit business over time, the IRS may require proof of a profit during at least three out of the last five tax years.

Fortunately, overcoming these obstacles may not be as difficult as they initially appear. Although the IRS wants to see proof of effort put into building an income-generating business, you do not have to quit your day job to make the new business your full-time occupation in order to qualify for tax breaks. As long as setting up your business does not involve a large capital investment, making a profit may be an attainable goal in most years. You can establish a profit motive by taking relatively inexpensive steps to market your products or services, such as advertising online and listing in the Yellow Pages. 

Once you have established a business, many of these expenses become tax deductible. The IRS defines an ordinary business expense as one that is common and accepted in your trade or business. Turning your hobby into a business also allows you to offset losses incurred on some transactions against profits earned on others. Even if your main source of income is not from the business, claiming business expenses and losses can help reduce your overall taxable income.

Generally, taxpayers are permitted to deduct ordinary and necessary expenses for conducting a trade or business. What qualifies as ordinary or necessary will vary according to the business. For example, you may be able to write off entertainment and transportation expenses, provided they are directly related to your business. You may also be able to hire your children to work for the business, which may help reduce both your family’s aggregate income subject to taxation and the effective rate at which that income is taxed. If you have a home office and equipment that are used exclusively and regularly for business, you could qualify for deductions for the business portion of property taxes, mortgage interest, rent, utilities, insurance, depreciation, and home maintenance and repairs.

Depending on the type and scale of your business, you may have to file papers with state and local authorities to register for sales and other business taxes. You may also have to obtain relevant licenses or permits. As a self-employed individual, you will be required to pay estimated income and self-employment taxes on a quarterly basis. If you have employees or are operating as a partnership, you must obtain an employer identification number (EIN) from the IRS. Your accountant can help you with these tasks and advise you on selecting the business entity that best suits your needs. While most businesses that emerge from hobbies operate as sole proprietorships or partnerships, you may wish to incorporate the business or form a limited liability company (LLC) as time goes on.

To demonstrate that you are serious about your business, consider drawing up a formal business plan that outlines how you intend to operate and grow the business. Detailed record keeping is essential, both for claiming deductions and for proving to the IRS that you are truly conducting a business. Set up a separate bank account for the business and apply for a separate credit card for business expenses. Attending industry events, subscribing to trade publications, posting a company website, and advertising on social networking sites can provide evidence of your investment in a for-profit business.

Turning a hobby into a business has its challenges. Be sure to do your homework before declaring yourself a business owner. Most importantly, consult your tax professional for more information.