If you’re like most small business owners, you started your company as a sideline and watched it grow. You may have another business or work for an employer while you build up your fledgling venture. And although you may not spend all your time on your small business, you plan for healthy bottom lines down the road. In the meantime, you can use your operating losses against your other sources of income and reap some tax benefits.
But what if the IRS comes along and questions whether your “business” is really just a hobby? Does it even matter? It turns out, it matters a lot. If the IRS determines that your business is actually just an unprofitable way that you pass the time and not a going concern, your losses will be denied but you will still have to pay tax on any net profit you make down the road.
The IRS takes several factors into consideration when labeling your venture as a business or hobby. In order to make sure that you stay on the right side of tax law, be sure to take these criteria into consideration when structuring your business.
1) The nature of the losses - Many businesses in the startup phase incur losses and the IRS is quite forgiving of that situation. Your business may also experience losses due to unforeseen or uncontrollable circumstances, and that is also acceptable. However, if the IRS sees ongoing annual operating losses with no end in sight based on the current business model, it is likely to deem the venture a hobby and disallow the losses.
2) Management skills - Whether or not you have the skills and knowledge to bring your business out of a loss position over time is an important consideration to the IRS. If you have never operated a business before and have no entrepreneurial education, the tax man will have less optimism that you can make your business profitable down the road.
3) Time invested - How much time you put into working in your business also has an impact on the IRS’s perception of it. If you just dabble at it on the weekends while you hold down another full-time job, it may decide that you are not investing enough sweat and tears into it to make a real go of things. Most hobbyists engage in their hobby on a part-time basis. Most business owners spend a significant amount of time trying to bring a company to profitability.
4) Money invested - Most businesses require a cash investment, whether small or large, on startup to get the venture up and running. From the perspective of the IRS, if you have money invested in your business, you are less likely to walk away from it and more likely to work hard to make it profitable.
5) Past history - If your business is too new for the IRS to get a true sense of potential, it will look at other businesses you have owned over the years. If you have a history of successful enterprises, it will be more inclined toward classifying your operation as a business.