What would happen if the IRS re-classified your business as a hobby?

It can happen.  The IRS defines a hobby as a revenue-generating activity that lacks a profit motive.  But what does that mean to you?

Most start-ups and small businesses have good years and not-so-good years.  There are those that will say that if your business continually functions in the red, maybe you really need to rethink your business strategy.  The IRS, on the other hand, will be looking at whether your business is really a for-profit business or is actually a hobby and the deductions or losses you have taken.  “The IRS will generally assume an activity is a business if it generates a profit 3 of 5 consecutive years…“.¹  If the business has a loss for 3 of 5 consecutive years, the IRS will take a closer look at what they consider the “facts and circumstances” to evaluate whether the activity is actually a hobby or qualifies as a for-profit business.

Why is this important?  Because if the IRS determines that your business doesn’t have a solid profit motive, they will re-classify your business as a hobby, then your past returns will be reviewed and deductions will be re-evaluated.   If they feel your *activity* is actually a hobby, they will add back the losses claimed by you that will result in back-taxes, penalties and interest.

So here are a few tips that you should consider in support of your for-profit business in the event you are ever reviewed by the IRS.  You want to be able to substantiate your business, and therefore entitled to any business losses you have claimed.  These practices include being properly licensed, have separate bank accounts and credit cards, payment of business taxes, good accounting and record keeping, appropriate insurance, a separate business phone line, log or business journal of time devoted to the business and documented actions taken to help make the activity profitable.²

¹ Brett Hersh, http://www.hbsbusiness.com
² Ibid.

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