The IRS Expects You To Prove That You Have A Real Business

With the April 15th tax deadline getting closer, many people who have turned their hobbies into businesses may be thinking there are all kinds of business deductions they will be able to take. Well, before you get too excited, let me forewarn you that the IRS has ways of determining whether you have a real business or merely a hobby. And, they’ll expect you to prove it.

Business Or Hobby In The Eyes Of The IRS

Unfortunately, there are no concrete rules for determining if you operate a hobby or business. The IRS does say that a business must actively be trying to make a profit. To prove your startup is a business, you need to be able to show that you are making an effort to turn a profit.

Proving intentions is not always simple. But, the most obvious way to meet the IRS’s requirements for a business is to actually make a profit. Usually, you won’t be considered a hobby if you make a profit for three out of the first five years you are in business. The amount you make can be small. If you can show the IRS you made a couple of dollars off your startup, you should be OK.

Making A Profit Is Not The Only Thing The IRS Looks At For Proof

While making money is great for your new business and the first couple of years can be difficult to show a profit, you may be relieved to know that money alone isn’t enough for the IRS to consider you a business. You need to proactively demonstrate that your business is valid.

First and foremost is legal documentation. Depending on how you structure your business, you’ll have different legal documents. For instance, are you a Sole Proprietor or an LLC? Are you in a partnership? If so, what kind, general or limited? Do you have all of the permits, insurances and identifications you need to function as the type of business structure you have filed as in your state? These are many of the questions that many hobby-turned-businesses don’t think of until it’s too late.

Record Keeping

Also, the IRS wants to know how you are keeping track of your business’s income and expenses. What kind of accounting records are you keeping? If the IRS doesn’t catch on immediately that you are treating a hobby like a business without establishing it legally, they will eventually. Businesses are taxed differently and you must file separately as a business.

Understand Tax Requirements And Legal Risks

I am not a tax attorney, but I do help people who want to evolve their hobby into a small business. I help my clients understand the legal risks before they happen and how to either avoid lawsuits or to understand that there are solutions to problems that may not be readily apparent to them. I help them understand the different ways of structuring their businesses and help them understand that the IRS will be looking at their business differently than they do their personal tax forms. Before you step into the business arena, let’s meet and make sure you are on solid ground so that you and your business can grow through the endeavor. Let’s make sure that your business has a strong legal foundation and a proper business plan so you can overcome the inevitable challenges and survive the business rollercoaster.