Creating a sound tax strategy is one of the more important parts of a financial plan. This is especially true for business owners. Every dollar saved on taxes is one that could be put back into the business.
Starting a business is difficult. I know… I’ve done it myself. Several of my clients have as well. We all agree that there tends to be more free time than free money early on. Wearing multiple hats is a fact of life when starting out. One job a new business owner needs tackle is the organizations financial health.
Not all businesses succeed. Half of them will fail within the first five years. Some simply close shop, while others might become a ‘side hustle’ for the owner. Some may have always been intended as an extra way to earn a bit more on the side.
For those who’ve decided to run a side job, there can be tax consequences. The IRS may classify the work as a ‘hobby’ rather than business. If that happens, many preferential tax treatments are lost. Worse yet, the new Tax Cuts and Jobs Act of 2018 does away with personal hobby income deductions.
The purpose of this article is help you understand how the IRS determines what is hobby income. This is especially important to understand during the first few years of a business since considering it can take a while to turn a profit. Knowing how to avoid the appearance of being a hobby can help put more money back into building your businesses instead of unnecessarily sending it to the Treasury Department.
Profitability is perhaps the main factor the IRS considers when determining if it’s a business or a hobby. The IRS considers it a for profit business if it turns a profit for three out of the last five years. That being said, they may question a business that shows only a minimal profit over that time. The assumption is that a for profit business will eventually provide enough income to support the owner.
If there are questions about the profitability of the business, the IRS will consider several other factors. Expenses could be reviewed to see if they’re comparable to what similar businesses budgeted early on. Losses from circumstances outside the owners control are also into account. They’ll see if there is any potential future appreciation of the business’s assets. The IRS would also want to gain an understanding on how the business owner plans to increase profitability moving forward.
Business Like Approach
This may come as a surprise, but the IRS is a serious-minded organization. They expect a business owner to approach their practice the same way. The IRS wants to see you putting in the time and effort needed to make the business a success. If you’re only spending a few hours a month having fun making money, the IRS will consider the activity a hobby.
Along with profitability, the IRS wants to see the business ran like a business. Increasing profitability means having a sound business plan in place. Does the owner keep good business records? Is there a serious approach to cost containment or process improvement? Are you reporting an advertising budget (Part II Expenses, Line 8) that shows you’re trying to promote your business?
You should already be doing this as the owner of a small business. If the IRS were to ever question your motives, you’ll easily be able to dispel any concerns if you are. You will also be able to show them the steps you’ve take to strengthen the business as time goes on.
Another factor used to decide if a business is actually a hobby would be the expertise the business owner has. If an owner has successfully started similar ventures, the new business is more likely to grow. The IRS will take that expertise into account. A lack of experience shouldn’t prevent you from trying a new business, but it is a factor.
The IRS may also consider your education and background when determining hobby income. Are you knowledgeable enough to succeed at the task? Have you studied and trained for the role? Are you competent enough to earn a living off of the business?
My own practice is a good example of this. It can take years for a financial advisor to gain footing. Just to start a Registered Investment Advisory firm, you need to become licensed by the Financial Industry Regulatory Authority or to become a Certified Financial Planner™ designee. That’s the kind of effort and expertise the IRS would look at when determining if the practice was a business.
Building a Tax Strategy
Every new business owner should try to take advantage of being classified as a business rather than a hobby. Hopefully this article gets you started on the right foot. Keep in mind that this is just the beginning part to establishing a tax plan for your business. Once you begin to grow, you should start planning on a more robust tax strategy that allows you to focus more income back into the business.