Tax Tips: Is it a hobby or a business?

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You've started a little enterprise in your garage or spare bedroom. And now it's tax time and you're ready to reduce your taxes by taking a whole bunch of deductions for this "business." Stop right there. You might not be entitled to take those deductions, and if you do, you may be asking for trouble.

Here's the key: Deductions for small businesses are only allowed to be taken when the venture is an actual business. A pyramid scheme is not a business. A "gifting club" is not a business. Making crafts and giving them away is not a business. You get the idea. The rules are fairly straightforward. Directly from the IRS website are the most pertinent points:

  • Does the time and effort put into the activity indicate an intention to make a profit?
  • Does the taxpayer depend on income from the activity?
  • Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
  • Has the taxpayer made a profit in similar activities in the past?
  • Does the activity make a profit in some years?
  • Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?

In general, you must turn a profit in at least three of the five last tax years in order for the IRS to consider your "business" a profit-making activity.

One very common issue with business losses relates to a taxpayer's participation in a multi-level marketing company. Research has shown that more than 90% of people lose money in these ventures, so I think that future of the IRS allowing deductions for these ventures is in question. Be very careful when your recruiter touts the "tax advantages" to getting involved in their scheme.

Tracy L. Coenen, CPA, MBA, CFE performs fraud examinations and financial investigations for her company Sequence Inc. Forensic Accounting, and is the author of Essentials of Corporate Fraud.

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