Sunday, October 9, 2011

How the Internal Revenue Service Looks at the Differences Concerning Hobbies and Businesses for Income Tax Requirements

Posted by Bapak at 6:09 PM

An old saying states that a small business is only a hobby before it is profitable. Or, at a minimum until it breaks even. For income tax reasons, the IRS is quite concerned about whether your business is a spare time activity. The reason for this is quite simple. They don't want to discover individuals taking income tax losses each year for an activity which appears to be an income tax shelter. If you have a company which persistently has a loss and it is within a niche in which the IRS has deemed to be a hobby previously, you ought to be very cautious.

First of all, the business has to be started with the full intent of making a profit. Also, you must have the ability to show that you have handled this venture like a business. This entails being organized by preserving records, separating banking accounts, and creating a valid plan to generate profit. The IRS will look at other things which include other sources of income and whether or not you treated your organization like a regular full-time profession. When you have a tax deductible loss, you'll need to show that you put in the work required to do everything possible to make a profit.

Furthermore, if you're able to reveal that your small business has been making money in the past, the IRS will be less strict with you. Historic earnings are generally proof that your business strategy made sense and that your losses are practical for income tax reasons.

One more thing that the Internal Revenue Service will more than likely inquire about is what areas have you practiced business previously. To illustrate, let's pretend you started a technology company in Silicon Valley which made $50 million once you sold this company. You then decide to go into semi-retirement mode and purchase a sizable vineyard in the same region. Understanding that it's difficult to generate money from the wine business, you have a loss for 3 years consecutively. In such cases, the IRS may determine that you had another source in which you acquired your money. Furthermore, you had zero past experience with the wine market. Since you're semi-retired, you're not actually working in the fields. In addition, you have a manager managing the vineyard.

Owning a winery may have been a lifelong aspiration you had. In addition, this a business whereby other folks in similar predicaments have gotten into. The IRS can take that fact into consideration. This market consists of a large amount of winery owners which have not been reliant on the income with this activity. As a result, the IRS will identify that your particular business is a hobby.

In this illustration, the IRS will likely examine the financial track record of the winery. If a 5 year period passes by and you earn profits in 3 of these years, the IRS will probably accept a tax deductible loss. The reason is that the business was making money more than half of the time within the past five years. In many cases, you will find a thin line between hobby versus business losses. Whenever you find yourself in a situation that is questionable, consult with a tax specialist.

Eileen Jacobs is an Enrolled Agent from Las Vegas, NV. She has over 30 years of tax and accounting experience.

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