For many of us it's tax time again. For others, tax time is just
around the corner. So, how was business this year? Did
you make a profit? If your business is very new, most likely
you made a loss. Oh well, at least you can write it off, right?
Well ... maybe. Whether you can write off your business losses
depends on whether your business really is a business or a hobby.
"Well, of course it's a business!", I hear you say.
"I don't put myself through this for the fun of it!".
In this article we look, first of all, at the things you need to
be doing in your business to make it very clear to the IRS that
you are, indeed, running a business and not merely indulging in
a hobby. The reason this is so important is that although
you have to declare and therefore pay tax on the income you make
from a hobby, you can't write off your losses and may not even be
able to deduct your expenses at all. Secondly, we'll take
a look at some of the common business tax deductions you should
be thinking about in the context of your business. Even if
you didn't have your act together last year in terms of keeping
records and receipts for all this stuff, at least you can get your
house in order for when this year's tax return is due.
HOBBY vs. BUSINESS
The crucial distinction between a hobby and a business is
whether you engage in the activity with a profit motive. Now,
by profit motive, we don't mean that "gee, it's really great
that I can make money doing something I love", we mean "I'm
doing this with the intention of making a profit and if I can't
make a profit doing this then I'll find something else to do that
will make me a profit". The difference is one of motive.
In the former, the motive for the activity was the doing - the enjoyment
inherent in the activity itself. Making money was an incidental,
albeit most welcome, benefit. In the latter, the motive for
the activity was to make a profit. That's not to say that
you can't enjoy what you choose to do to make that profit, it's
just that your primary objective must be to make a profit such that
if this venture is inherently unprofitable, you would presumably choose
not to pursue it. With a hobby, on the other hand, even if
the activity was inherently unprofitable, it is something you would
choose to do anyway.
OK, so much for your own subjective intentions. How does the
IRS decide whether you truly have a profit motive? There are
two ways it goes about it. The first is an objective test.
Quite simply, the IRS will look at your tax returns for the last
5 years and if you made a profit during at least 3 of those years,
you will satisfy the profit-motive test. If you don't meet
this test or if your business is new and you haven't filed 5 tax
returns, then the IRS will apply a subjective standard. In applying the
subjective standard, the IRS auditor considers and weighs several
factors, including:
=> Businesslike Manner of Carrying On Activity
The IRS will look at how you carry on your activity. Do you
keep a good set of books and records or do you chuck receipts into
a battered shoebox? Do you have separate bank accounts for
your business? Do you invest in advertising, marketing and
promotion?
=> Time and Effort Invested
Is your business a sideline or something you pursue more or less
full-time? Obviously if you devote substantially all of your
available time to the activity, the more likely it is that you have
a profit motive since that is your primary source of income. Things
can be trickier if you work full-time and your business is something
you pursue on the side. Just be sure you can demonstrate an
ability to devote substantial time and effort to your business.
Unlike a hobby, a real business in which you have a profit motive
demands time and effort. It's NOT something you just don't
get around to this week because "things came up".
With a hobby you can do that. With a business you can't.
=> Track Record of Profit-Making Ventures
If you have a history of involvement in profit-making activities
in the past, this will be relevant to your ability to make a profit
in your current venture. Conversely, if you have no track
record at all of involvement in profit-motivated pursuits, the IRS
is going to be looking for evidence that you know what you're about
and have sufficient experience and expertise to turn your activity
into a profitable sideline.
=> Nature of Losses
The nature of the losses you claim will also be a relevant
consideration. If you're a start-up, substantial first year
losses are to be expected. After that, however, you should
be demonstrating a shift towards profitability. Your second
year may still show a loss but it should be a smaller one that your
first and your third should be smaller again than that, and so on.
=> Changes in Operations
If you continue doing things the same way, day in day out even when
they're clearly not working to make you a profit, that's a strong
indication that you're engaging in a hobby and that you don't have
a profit motive. On the other hand, if you can demonstrate
changes in operations to attempt to fix what isn't working for you,
this will lean towards a profit motive.
=> Profit Patterns
The IRS will also be looking for profits in some years, even if
losses occur in others. A pattern of small profits and large
losses every year, year in, year out will raise suspicion.
This is just a sampling of the types of factors the IRS will
give weight to in adjudging whether your "business" is
truly a business or a hobby. For more information, visit the
IRS website at http://www.irs.gov.
COMMON DEDUCTIONS
OK, now that we all have healthy profit motives and are
therefore running serious businesses here, let's finish up with
a quick look at some of the common business deductions for home-based
businesses:
=> Home office deduction. For a complete article on this
deduction, read "Taxing Times ... The Home Office Deduction"
at http://www.ahbbo/homeofficetax.html .
=> First year expense deduction. You can deduct up to $20,000
worth of equipment as a current expense during your first year of
business with this deduction. Otherwise, you would have to
deduct it over a period of years depending on the depreciation schedules
for the assets concerned.
=> Auto expenses. If you use your car for business purposes,
you can claim mileage or depreciation. The mileage method
allows you to deduct the amount per mile the IRS allows for
the particular year. The depreciation method allows you to
take a depreciation deduction on the cost of your car and add to
that all costs and expenses associated with running your car including
maintenance.
=> Health insurance payments (proportion).
=> Business insurance premiums.
=> Contributions to retirement plans.
=> Continuing education expenses related to your business.
=> Gifts valued at up to $25 per person per year.
=> Internet and email services - ISP, webhosting etc..
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Elena Fawkner is editor of the award-winning weekly ezine, A Home-Based
Business Online, a down-to-earth publication containing practical
home-based and online business ideas, telecommuting job listings,
original articles, free e-books and much more. She also runs the
A Home-Based Business Online website at at http://www.fawkner.com.
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