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Three Main Criteria for Turning a Hobby into a Business

Feb 1, 2020

The line between a hobby and a business isn’t always clear-cut. But businesses hold distinct tax advantages over hobbies. Businesses can deduct losses against income, while expenses leading to a loss from hobbies are considered a personal loss and can’t be deducted.

If a hobbyist devotes significant time to creating an item or offering a service – and often fields questions about turning the activity into a business – it may be time to take the leap. Upon review, the hobby may be a few short steps away from business classification.
Here are the main criteria for crossing the business threshold.

1. For-Profit Intent

For an activity to be deemed business-related, it must demonstrate for-profit intent. This is arguably the most important criteria, as emphasized by the tax and case law authority.

As an example, a yacht owner may deduct expenses from nautical pursuits under the guise of running a charter business. However, without documentation of for-profit intent, tax authorities would likely view the endeavor as a recreational sideline.
In this regard, having a business plan is essential. The plan should outline specific business-driven goals, such as a gross margin target, strategic marketing objectives to promote growth, and an overall strategy for achieving profitability. Note that an objective just to “break even” would not be considered a legitimate long-term business goal. In such a case, the activity would likely remain a hobby.

Technically, there is no statutory deadline or requirement for turning a profit, as businesses can often run losses for several years. However, the existence of revenues and year-over-year growth would give a strong indication of a business foundation compared to a hobby.
The business plan should also outline internal controls for proper record-keeping, with all receipts and expenses appropriately reflected in financial statements.
Implementing robust methods of operations further demonstrates an earnestness for achieving profitability, as do instances where the taxpayer expects to see future profits from depreciation of the assets used in the activity. In all cases, it’s important to document these activities.

2. Level of Expertise

Whether focused on a product or service, it helps the business case if a taxpayer is already an expert in the field of such chosen trade or business.
Returning to the charter boat activity example, an investment banker would have a more difficult time than a nautical expert in making the case to tax authorities the activity is a legitimate business.

However, new entrants into a field are not automatically disqualified from obtaining trade or business treatment. At a minimum, they must demonstrate a passion for learning the industry – for example, trade show attendance, participating in instructional classes, registering for a unique license, or hiring a consultant to acquire expertise.

3. Nature of the Business

It is also important to assess the nature of the business. Tax authorities deem activities suspect where they inherently include a personal pleasure aspect or recreational element.
For example, a cigar aficionado who runs a smoking lounge for a small private membership fee, but runs continuing losses, would have a difficult time making the business case to tax authorities that the losses are deductible.

Time spent is also considered. If an individual is spending 30 to 50 hours to run and manage an activity – this, too, bolsters the business case. Furthermore, the activity may be a dependent source of income to the individual. This point is also persuasive for the business case.

Taking the Leap

Rather than using an objective score-based system, tax courts weigh all facts and circumstances to conclude whether an activity is a business or a hobby based on the statutory guidelines. No one factor dominates over another. Where a business has a recreational feel to it, other criteria become more heavily relied upon to demonstrate business legitimacy.
In assessing all these factors, the activity may only be a few criteria away from business classification.
As a first step, it’s wise to speak with a tax expert. They can help review the time and resources devoted to an endeavor – and whether it’s finally time to turn that hobby into a business.

Business Tax Quarterly - Winter 2020

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