A popular cliche states that a small business is “only a hobby before it is making real money”. Or, at least until it breaks even. For income tax purposes, the IRS is very concerned with whether your enterprise is a spare time activity. The reason for this is basic. The IRS doesn’t want to discover individuals taking tax deductible losses each year regarding an operation that resembles a tax shelter. If you have a business which continually has a loss of profits plus it falls into a niche in which the IRS has considered to be a traditional hobby, you should be very cautious.
To begin with, the business should be opened with your intent of generating positive income. Furthermore, it’s essential to be able to show that you have managed this opportunity like a business venture. This requires being organized by preserving records data, separating bank accounts from personal use, and creating a valid plan to make a profit. The Internal Revenue Service will be looking at other things including additional types of earnings and whether or not you handled your business as if it were a regular, full-time profession. Should you have a deductible loss, you’ll need to be able to demonstrate that you put in the actual time and effort to do everything possible to make a profit.
In addition, if you can show that your company has been profitable in past years, the IRS will likely be less strict with you. Historic profits are valid evidence that the venture idea was logical and that your net losses are reasonable for tax reasons.
Another thing that the Internal Revenue Service will likely ask about is which areas have you engaged in business prior to this venture. For example, let’s pretend you began an internet business in Silicon Valley and made $50 million when you sold this company. Then you make a decision to go into semi-retirement mode and buy a big vineyard in the same region. Realizing that it’s difficult to generate income from the wine business, you incur negative earnings for 3 years in a row. In such cases, the IRS may identify that you previously enjoyed some other source where you received your money. Furthermore, you had no previous experience in the wine sector. Since you are semi-retired, you are not actively employed in the vineyard. On top of that, you’ve got another individual managing the vineyard.
Buying a vineyard could have been a lifelong dream you had. This is also a business whereby other people in equivalent cases have gotten into. The IRS can take this into consideration. This market consists of a large amount of vineyard owners which have not been reliant on the cash flow with this business. Hence, the IRS will identify that your particular vineyard is a hobby.
Using this example, the IRS will likely evaluate the economic track record of the business. If a 5-year duration passes by and you make a profit in 3 of those years, the IRS will likely approve a business loss. The reason is that the winery was profitable most of the time within the past five years. Many times, there is a thin line between hobby and business losses. Whenever you realize you are in a predicament that is questionable, talk to a tax expert.