You just retired, kind of, and you figure now is the time to put your creative talents to use and maybe sell some of your crafts. Or maybe you were just laid off and you are interested in starting your own business so you can get out of the syndrome. This second scenario is what my husband's nephew just experienced. He just got laid off for the third time from a big bank. He said he's tired of the roller coaster and he wants to start his own business selling his woodworking crafts. He asked one of the most common questions I get, "Do I have to make a profit so the IRS won't call my business a hobby?"
The IRS says, "An activity is presumed for profit if it makes a profit in at least three of the last five tax years." But what if you don't make a profit? My business didn't make a profit for five years. But my business met other IRS requirements to keep it from being considered a hobby. First, it was not the kind of business that is typically thought of as a hobby (consulting and selling e-books). Second, I did all the things a real business must do to show it was not a hobby. If your business could be considered a hobby (a craft business like the one above), ask yourself these questions (the ones the IRS will ask):
Does the time and effort put into the activity indicate an intention to make a profit?
Do you depend on income from the activity?
If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
Have you changed methods of operation to improve profitability?
Do you have the knowledge needed to carry on the activity as a successful business?
Have you made a profit in similar activities in the past?
Does the activity make a profit in some years?
Do you expect to make a profit in the future from the appreciation of assets used in the activity?
Legitimate Business Activities
If you want your business to be considered legitimate, you must act like a real business:
- Keep excellent records showing income and expenses
- Perform marketing and sales activities to attract and keep customers
- Pay sales taxes and other federal, state, and local taxes
- Set up as a limited liability company or corporation, rather than as a sole proprietor
I can't guarantee that the IRS won't still look at your business as a hobby even if you do these things, but these activities can give you more credibility with the IRS. Remember, I'm not a CPA or tax attorney. I am just presenting general information to think about and discuss with your tax adviser.
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