How Can I Turn My Hobby Into a Business?

How Can I Turn My Hobby Into a Business?

Maybe you see how an off-hours activity can become a profitable company. Or perhaps you have a spouse who brings in sufficient income to support both of you, and you’d like to spend your days at home painting (or photographing) animal portraits and then selling those portraits to their owners. Can you write off the expenses relating to your studio, such as a portion of the utilities, property taxes, rent or, if you own your home, depreciation? The answer is MAYBE, if you know the rules.

Conducting an activity like a business

One of the first things the IRS will consider in determining whether expenses incurred in your activity are deductible — not only against your income from the activity but also other income — is whether the activity is being conducted as a legitimate business with a goal of making a profit. If the activity is not being pursued for profit, losses from the activity cannot be used to offset other income. In determining whether your activity is a legitimate profit-making business rather than a hobby, the IRS will consider the following:

1. Are you maintaining accurate books and records? For example, do you have a separate bank account for the business? Additionally, engaging accounting and tax professionals to help with the preparation of financial statements and tax returns will show that you are serious about your business venture.
2. Did you research and prepare for the activity by studying accepted business, economic and/or scientific practices? Or, alternatively, have you hired a professional familiar with the industry to do so?
3. Are you operating the activity in the same way as similar profitable businesses are operating such an activity?
4. Are you pursuing the activity full time or part time? If you are only spending part of your time on the activity, have you hired competent and qualified help to take the reins of the business when you aren’t around?
5. Have you secured the suppliers and/or products necessary for the activity?

If, in the eyes of the IRS, you aren’t pursuing your activity for profit, you won’t be able to use a loss from the activity to offset other income, such as salary, rental or investment income. This pursuing-an-activity-for-profit rule applies to individuals, partnerships, S corporations, and estates and trusts. However, it does not apply to C corporations.

Special rule for determining if an activity is a profit-making activity

There is a special presumption rule, however, under which an activity is treated as being a for-profit activity even if it has losses. Under this rule, an activity is treated as a profit-making activity if the gross income from the activity exceeds the deductions attributable to such activity:

1. for any two of seven consecutive tax years, in the case of an activity which consists in major part of the breeding, training, showing or racing of horses, or
2. for any two of five consecutive tax years, in the case of any other activity.

This presumption applies with respect to the second profit year and all years after the second profit year within the five- or seven-year period beginning with the first profit year. And this presumption only applies if the activity is substantially the same activity for each of the relevant tax years, including the year in question.

For example, assume that you begin a pet portrait business and operate it from 2020 through 2024 (i.e., five years).

• For 2021, 2023 and 2024, your deductible expenses exceeded your gross income and thus you have a loss.
• However, for 2020 and 2022, you have income from the activity of $15,000 for each year.
• For 2021, 2023 and 2024, your deductible expenditures for your business exceed your gross income from the activity.
• For 2020 and 2022, however, you have income from your sales of pet portraits.

Because of the presumption rule, you are presumed, for 2022, 2023 and 2024, to have engaged in the activity of painting pet portraits for profit since, for two years of a five-consecutive-year period, the gross income from the activity ($15,000 for each year) exceeded your business deductions for each year.

What if you don’t meet the presumption test?

That can be OK, too, because it doesn’t mean that your activity is automatically not considered as being engaged in for profit and that your losses are not deductible. It just means you might have to prove by other means that you are running your activity as a for-profit enterprise. In such cases, having a tax or financial adviser on board who has experience with the type of business you are operating can be extremely helpful in negotiating with the IRS and explaining to them why the business wasn’t profitable and how you are working to make it profitable in the future.

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