Is It a Hobby or a Business? It Matters

Suppose you do woodworking or pottery in your basement and sell some of your wares at a crafts show. Is the activity a ?business? or is it just a ?hobby?? There is a big tax difference.

Reason: If you are operating a business, you can claim a tax loss to the extent your annual expenses exceed your income. In fact, it?s not unusual to run losses the first few years of operation. You can use a loss from a sideline business to offset other highly taxed income on your personal tax return, such as wages from your full-time job or investment earnings.

On the other hand, if the activity is one in which you are ?not engaged in for profit? (i.e., it?s a hobby) your expenses are deductible only up to the amount of the income received from the activity. In other words, you can?t claim a tax loss. For this purpose, deductions must be claimed against your hobby income in the following order: (1) expenses that would otherwise be deductible (e.g., taxes, interest or casualty losses); (2) operating expenses other than depreciation; and (3) depreciation and other basis adjustment items.

To add insult to injury, if an activity is classified as a hobby, the expenses must be deducted as miscellaneous expenses. Miscellaneous expenses are deductible only to the extent the annual total exceeds 2% of your adjusted gross income. So youmay end up with little or no tax benefit from your hobby expenses.

How can you distinguish a business from a hobby? This issue is often contested in the courts. Although each case is decided on its own merits, the IRS has developed a list of critical factors, including the following:

*The taxpayer?s history of income or losses with respect to the activity.

*The amount of occasional profits, if any, that are earned.

*The cause of the losses.

*The success of the taxpayer in carrying on other similar or dissimilar activities.

*The financial status of the taxpayer.

*The time and effort expended by the taxpayer in carrying on the activity.

*The expertise of the taxpayer or his advisers.

*The manner in which the taxpayer carries on the activity.

*Expectation of profit by the taxpayer.

*Expectation that assets used in the activity may appreciate in value.

*Elements of personal pleasure or recreation.

No single factor on its own is conclusive. But if the factors are heavily weighted in one direction, it can make or break your case.

Ace in the hole: The tax law presumes that an activity is not a hobby if you have shown a profit in any three out of the last five consecutive years. This tax presumption is even more lenient for an activity involving the breeding, training, showing or racing of horses. In that case, the activity is presumed not to be a hobby if it shows a profit in only two out of the last seven consecutive years.

Of course, the IRS can rebut the tax law presumption by offering proof that the activity is actually a hobby, putting the ball back in your court.

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