Everyone is talking side hustles these days, and it happens even more around tax time.  So you look at your taxes for the year and think, I need a business to be able to deduct more things, right?  Well, it’s not quite that easy.  You see the IRS has specific rules regarding small businesses and self employment income to be eligible to deduct business expenses.   The most notable of course is your business must be expected to generate more revenue than deductions (profits) in 3 out of 5 operating years or it may be disqualified and considered a hobby, with no write offs.

Here is more info from the IRS website (https://www.irs.gov/newsroom/know-the-difference-between-a-hobby-and-a-business):

Key questions to consider

Is the activity conducted like a business?

  • Does the taxpayer maintain complete and accurate books and records?
  • Does the taxpayer do the activity in the same way as similar profitable activities?

Does the taxpayer change their methods of operation to improve profitability?

  • Does the taxpayer advertise or promote the activity?
  • Does the taxpayer work to secure suppliers or products necessary for the activity?

What is the taxpayer or their advisors’ expertise in the activity?

  • Has the taxpayer, or their advisors, prepared for the activity by extensive study of its accepted business, economic, and scientific practices?
  • Does the taxpayer follow the accepted business practices or advice of experts when they pursue the activity?

Is the activity a main source of income for the taxpayer?

  • Does the taxpayer spend much of their personal time and effort on the activity, particularly if the activity does not have personal or recreational aspects?
  • Has the taxpayer pursued the activity full-time or part-time?
  • Does the taxpayer employ competent and qualified persons to perform the activity?

Has the taxpayer made or expect to make a profit?

  • Has the taxpayer engaged in similar activities in the past and converted them from unprofitable to profitable enterprises?
  • Does the taxpayer intend to profit from appreciation in the value of assets, such as land, used in the activity?

Is the activity profitable in some years?

  • Does the taxpayer occasionally have a small profit from the activities that is offset by large investments they have made or suffering large losses?
  • Has the taxpayer made substantial profit from the activity?
  • Could the activity earn a substantial ultimate profit in a highly speculative venture?

Do any losses from the activity fall beyond the taxpayer’s control or are they normal in the startup phase of their type of business?

  • Do the taxpayer’s losses continue beyond the period which would be necessary to bring their activity into profitable status?
  • Are the taxpayer’s losses because of things beyond their control, like drought, disease, fire, theft, weather damages or depressed market conditions?
  • Has the taxpayer had a series of years in which they made a profit?

Does the activity have elements of personal pleasure or recreation?

  • Does the taxpayer have personal motives for doing an activity, especially where there are recreational or personal elements involved?
  • Does the activity lack appeal other than profit?

Claiming profits and losses

If taxpayers aren’t trying to make a profit with their hobby, business or investment activity, they can’t use a loss from the activity to offset other income. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts and S corporations. It doesn’t apply to corporations other than S corporations.

If a taxpayer receives income from an activity that is carried on with no intention of making a profit, they must report the income they receive on Schedule 1 (Form 1040)PDF, line 8.

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James A. Daniel

James A. Daniel - Financial Planner


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