Turn Your Hobby into a Business Tax Break & 10 Tips To Make Your Hobby Tax Deductible

Kay Bell for BankRate.com writes: Hobbies provide a great way to relax from the daily grind. For many people, they also offer a way to make extra spending money. Be aware, however, when your hobby produces income, you owe tax on it. You can reduce your taxable hobby income by deducting your hobby expenses, but this tax break is limited.

Allowable hobby deductions

You can only deduct expenses up to the amount of money you make on the hobby. Even then, hobby expenses, along with other miscellaneous expenses you itemize on Schedule A, must come to more than 2 percent of your adjusted gross income before you can deduct them.
If you find you are regularly making money from your hobby, it might be to your tax advantage to turn the sideline into a business.  It's not as difficult as you might think. If you operate as a sole proprietor, you report the income on your Form 1040 tax return and you have more options when it comes to deducting your expenses.

Hobby vs. business

The Internal Revenue Service defines a hobby as an activity you pursue without expecting to make a taxable profit. Basically, you do it because you like it, regardless of the cost.
But if you demonstrate that you are involved in an activity with the expectation of making money on it, the IRS will consider it a business. As such, you'll be able to deduct expenses directly from your income. You even can deduct overall business losses in the years you don't turn a profit. You must, however, make the right moves to convince the IRS that your sideline is a legitimate business.

What constitutes a business

The IRS uses two tests in determining whether your activity is a business or a hobby.
First, the profit test demands that you show you earned money on the activity in three out of five years.  If you can't meet the profit test, you get another chance to convince the IRS that you are running a business by passing the factors-and-circumstance test. Here, the tax agency takes a subjective, individualized look at your pursuit.

What the IRS examines

• Whether you carry on the activity in a businesslike manner. This includes, for example, keeping good books and records, promoting your business and holding down costs where possible.
• How much time and effort you devote to the enterprise.
• Whether you depend on income from the activity for your livelihood.
• If your losses are due to circumstances beyond your control or are normal for a business in its startup phase.
• Whether you change your methods of operation in an attempt to improve profitability.
• The knowledge and background you (or your advisers) have in running such a business.
• If you were successful in making a profit in similar activities in the past.
• Whether the activity makes a profit in some years and, if so, how much.
• Whether you can expect to make a future profit from the appreciation of the assets used in the activity.
• The element of personal pleasure involved in the activity. That doesn't mean you can't enjoy your new business, but you better be getting more out of it than just a good time.

IRS looks at everything

In determining whether you are carrying on an activity for profit, the IRS says all the facts are taken into account. No one factor alone is decisive. So be prepared to come through in several areas to convince the IRS that you're making a good-faith attempt to run a business and not just looking to illegally claim the more-expansive business tax breaks. By successfully transforming your hobby into a business, you'll be able to deduct your associated expenses on Schedule C or C-EZ without worrying about a percentage limitation. You might even find a few more you can take, such as one for the home office you set up to take care of your new endeavor's administrative chores.  And if you have an occasional year where you lose money, the loss can help reduce your other income and lower your tax bill.
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10 Tips To Make Your Hobby Tax Deductible

From Robert W. Wood a Contributor for Forbes writes Will the IRS pay for your hobby? The short answer is no. The more nuanced answer is sometimes, provided that you make it enough of a real business. If you want to avoid any IRS hassles my standard advice is to keep your business and personal pursuits separate. But most of us like two-fers, and current economics make multipurposing even more compelling.

Say you lose $20,000 a year in the “business” of breeding, training and caring for whippets. You can report the loss on Schedule C to your Form 1040 and write if off against your salary. Assuming your combined state and federal tax rate is 40%, your whippet breeding really only costs you $12,000. See  In Pictures: Convincing Uncle Sam To Subsidize Your Hobby.

If your whippets are a hobby, you can’t claim a loss. But before you decide to turn your nondeductible hobby into a deductible business, be careful. This is an area of intense IRS scrutiny. The IRS issued a new manual to help agents ferret out taxpayers improperly writing off hobbies. Here are five tips for getting business tax treatment for a pursuit you enjoy.

1. Match income and loss. The IRS is less likely to question whether you’re engaged in a businessif your income from the activity exceeds your expenses. See The ABCs of Hobby Losses and Profit Motive.

2. Keep good records. It matters whether you conduct yourself in a businesslike manner. If you keep good records and hold yourself out as running a business, it will help. See Tax Return Filed? Now Consider Your Records.

3. Show a profit three years in five. If you can manage to eke out a profit three years out of every five (or two years out of seven, if your activity is horse breeding), the IRS will presume you’re in business to make a profit. That presumption is worth a lot since you probably won’t have to mud wrestle with the IRS over a more amorphous facts and circumstances test.

4. Plan income and expenses. Our tax system is annual and so are profit-and-loss determinations. You may have more control than you think over when you receive income and especially when you incur expenses. That control can help you make a profit three years out of five. See When You Have Income But No Cash.

5. Delay a profits determination. You can elect to defer the determination of profit motive until the fourth year of your “business,” or your sixth year in the case of an activity involving horses. To make this election you file a Form 5213, postponing the determination of whether you’ve met the three-out-of-five-years profit presumption. The idea of the election is to give you time to ramp up and achieve a profit.

Warning: Most advisers don’t recommend this election since it could flag the profit-motive issue. Plus, it has the effect of extending the IRS statute of limitations beyond the normal three years. The IRS can examine all the years in question after the deferral period has passed. For more about the IRS statute of limitations, click here.

In Five (10 Total) Tips to Make Your Hobby Tax Deductible, I covered five tax tips for deducting your hobby. If you can do it legitimately, transitioning from hobby to business lets taxes subsidize it. Fair warning: it can be tough to convince the IRS and you may have to go to court.

But if you’re committed, here are five more tips to help smooth out that bumpy uphill road:

6. Do it full-time. The IRS is more likely to query writing off a “hobby” against income from your regular job. If you work 40 hours a week in an office and raise chinchillas on the side, does that mean the chinchillas are just a hobby? No, but the IRS is more likely to consider it a business if you do it full-time.

7. Write a business plan. The IRS looks for businesslike activity. One of the auditors’ checklist items is a business plan. Write one up and try to look businesslike in all things. See The ABCs of Hobby Losses and Profit Motive.

8. Hire experts and become one. The more expert you become and the more you engage others the more businesslike you’ll look. If you have advanced degrees or hire consultants to help you grow prize orchids, raise toucans, or race mopeds, it may be easier to  convince the IRS.

9. Don’t enjoy it too much. Do what you love? Maybe, but the IRS thinks personal pleasure is an indication your “business” is a hobby. Don’t enjoy it too much. See When Taxpayers Go Fishing For Deductions.

10. Combine activities. A stand-alone activity with losses might be combined with a profitable activity. What you call a single activity should be accepted by the IRS unless it’s artificial. You can’t combine profits from working as a tech consultant with losses from breeding whippets as a single business activity. But a profitable sideline selling handcrafted dog collars and an unprofitable sideline boarding dogs might be combined on a singleSchedule C. It could make it easier to show a profit three years out of five.

Bottom line? It’s good to keep your business and personal life separate, but if you generate income from a pastime consider becoming more businesslike. Just don’t turn an activity you love into a daily grind!