Tip: If you are considering developing a hobby into a profit-making business, know that the IRS examines these businesses very thoroughly.

Most of us enjoy time away from business, especially when we can indulge in an entertaining hobby. These hobbies can be as varied as the participants—race cars or race horses, quilting, gun-smithing, gardening, wood-working, and hiking, just to name a few. A number of people earn money from their hobby. Sometimes it is from selling puppies and other times, it is from crafting and selling jewelry. When money is paid to you, it becomes income and income must always be reported on your taxes, regardless of the source.

So, you say, “I made money from my hobby, and it is now a business.” I reply, “Not necessarily.” There are many points which govern whether a hobby is truly a business, and all of these have to be considered before a determination can be made. Consider these points:

• How much time do you regularly spend working on your business? This time should be consistent, and at least 45 minutes a day at least 4 days a week or another alternative is that you could spend 6 hours one day a week working on your business.
• Are you attempting to make a profit from the effort, time, and money you invest?
• Do you keep accurate records of all transactions, business activities, appointments, or in other words, do you document everything that happens within the business?
• Are you depending upon income from the activity of this business?
• Have you ever made a profit in this business or one like it?
• Do you have adequate knowledge of this business to succeed?

If your hobby activities have been not-for-profit in the past, you will need to prove to the IRS that you have revised your methods of business activity and have changed them into a profit mode. Most of the determination will rest upon “can this hobby made a profit?”

The IRS defines “business” as an activity, when carried out, that has a reasonable expectation of making a profit. They go further, saying that profit must be made in 3 of the last 5 years of business activity. Some businesses have a different criteria, such as the horse industry. In that type of business, you have to show profit for 2 of the last 7 years, and the business activities have to primarily be showing, training, breeding, or racing horses.

If you have a hobby with income, you cannot deduct your hobby expenses against that hobby income. This is why many people choose to evolve their hobby into a business. Once you establish a legitimate business, you are allowed to deduct ordinary expenses against the business income. The usual rule applies here: keep good and accurate records. You need to offset your expenses only with the income from the business. You cannot offset them against other income that you might have, such as a salary from another business. This can automatically trigger an audit for you, if you do this.

Audits hold a bit of fear for everyone. Even if you are correct, you are going to incur costs when facing an audit, and for a small business, that frequently hurts. Small business owners, earning between $100,000 and $200,000 a year, appear to be the most frequently audited group (4.2%). Although the IRS claims to audit generically, there are some targets they seem to aim for. If you have a hobby that you have turned into a business, know that one of the top 5 reasons for an IRS audit is claiming “hobby losses” against your new hobby/business.

Once you face an audit for “hobby losses,” things get complicated. Here is where you will benefit from consulting a tax lawyer. The IRS will require that you prove that your business has a reasonable expectation of profit-making, and that it is legitimate, not just a hobby. Your tax lawyer can represent you in the audit, and once you are his client, he will be able to protect you as well as your other interests which are not involved in the audit. Your tax lawyer can also negotiate with the IRS agents on your behalf, easing your stress as he works through the different issues with your welfare in mind.

If you are considering developing a hobby into a profit-making business, know that the IRS examines these businesses very thoroughly. Regardless, follow your passion, be a good business owner doing everything the right way, and if you should have IRS issues, call a tax lawyer to help you get through them.