There is a famous quote that says, “If you do what you love, you’ll never work a day in your life.” This quote may hold true, but unfortunately the IRS may have some questions related to how much you enjoy your new business, and if it is actually engaged in for profit. Many times a new business may skirt the line of a hobby and a career, in which case there may be tax consequences that need to be understood and considered.
Activities that involve an element of personal enrichment or recreation are magnets for IRS scrutiny. This does not necessarily mean that you cannot deduct expenses for an activity you enjoy; but in order to maximize your deductions you must be prepared to show that the activity is a business from which you intend to make money. You do not actually have to make a profit each year, but you do have to be able to show that you have a profit motive.
It’s not that the IRS is concerned one way or the other with your personal enrichment per se; instead, its focus is on the effort to produce a profit. Activities enjoyed “merely” for emotional, spiritual or intellectual — rather than fiscal — improvement, on the other hand, are much more likely to produce losses rather than profit.
What does this hobby/business distinction mean to you? If the IRS determines that your activity is not profit-driven, your deductions will be limited to the amount of income the activity generates. That means you cannot use a loss from that activity to offset other income, such as salary or investments, so your extra expenses bring you no tax benefit. In order to have a usable loss, it is important that you are able to show the IRS that the activity was indeed established with the intention of making a profit.
An important element of building a successful business is having a plan. It is also the most important document to support your profit motive to the IRS. Create it, review it annually at a minimum, modify it when needed, and take steps to improve the business. If you treat the effort as a business, others will too!
Please feel free to contact your L&B professional at 858-558-9200 to further discuss these details.