Since the recession began, a number of new businesses started to supplement or substitute incomes during situations of job loss. It is important for these small businesses and their owners to be cognizant of the hobby loss rule instituted by the IRS.
Business or Pleasure?
The hobby loss rule relates to business expenses used as a deduction for activities considered to be hobbies by the IRS. The rule can affect and limit how you account for write-off deductions for these expenses.
The IRS will make the determination about whether or not the activity you are pursuing is a hobby. The deductions for any legitimate expenses of a business may not be greater than income from the activity each year. Deductions from a side business can not be claimed as business deductions and can only be claimed as miscellaneous itemized deductions. To claim in this category, the deductions must be more than 2% of adjusted gross income. All income from a hobby is fully taxable. However, losses that total more than the income cannot be held over into future years and are essentially lost for good.
Hobby Loss Rules and Investments
As the economy has been rocky and the stock market; shaky, investors have been looking for other places to invest money. One option has been to invest in hobby-type activities such as collectibles that are basically guaranteed to increase in value. Most investments into collectibles, such as jewelry and coins, are considered to be safe investments.
If the IRS considers your investment project to be a hobby, you are subjected to the hobby loss rule. You are required to report all income and pay taxes on capital gains from collectibles that have been sold. Typically, only veteran collectors can claim their collectible activities as a business, however anyone can present their case to the IRS about the legitimacy of a business activity.
How to Prove Legitimacy
The IRS will consider income generated from the same activity for three or more consecutive years out of five to be a business for profit. You can help prove the legitimacy of a business in the following ways:
- Create a Business Plan: Creating a formal plan that outlines your expectations for making a profit on your activities.
- Keep Records: Separate the accounting records of your business activity from your personal finance information. Make sure to track all income and expenses accurately.
- Establish a Presence: Open a bank account and a credit card for the business. Do not rely on your own accounts for financial activities for the business.
- Proof of Effort: Be ready to show the IRS that you put in much time and effort to establish your activities for business purposes.