Before we continuing moving through form 1040 and look at income you first need to know if your business is considered a hobby or a business by the IRS. Not every venture you consider a business is considered a business by the IRS, it may be considered a hobby which does not allow you to deduct expenses in the same manner as a business. With the Tax Cuts and Jobs Act there are even more limitations to what hobby expenses can be deducted. Specifically they have now been limited to cost of goods sold, but the income still must be recognized.
As a general rule of thumb a business that is profitable at least three out of the last five years is considered a business. This is actually different for certain horse related businesses, the IRS gives an exception here and the general rule of thumb is two out of seven years. This is a general rule of thumb, a business can still be challenged and considered a hobby if it meets the profitability guidelines, however the burden of proof that the company is not a business, but rather a hobby falls on the IRS. On the other hand a company that does not meet the profitability guidelines can be considered a business, but the burden of proof falls on the taxpayer.
What's a Hobby?
A hobby is an activity that is done because it provides entertainment, joy, etc. A hobby can make a profit, but that's not its main purpose. A business on the other hand has a primary purpose of making money. This can be a hard definition to grasp in the equine and agriculture industries. After all there are often jobs that could replace the income you generate from your business and they may even be less time consuming and not as hard on your body. Realistically many of our clients love what they do and turn that passion into a job. It's very important for businesses in our industries to establish themselves as a business and not a hobby. To aid in the differentiation between a business and a hobby the IRS has identified nine characteristics of a business. The evaluation of a business looks at these characteristics as a whole, one characteristic does not solidify or disqualify an activity as a business. Let's look at each of these:
A Business-Like Manner
Is the activity conducted like a business? Are separate bank accounts kept? Does the business have it's own set of financial books? What is the industry norm for a business and does the activity have those characteristics? If you have a few broodmares in the pasture you breed every year and occassionally turn a profit on the babies chances are you don't have a registered entity that owns those horses. You probably don't keep a separate set of financials for those horses. You might not have a bank account you pay the related expenses from, etc. In that case you don't have a business, you have a hobby.
Time and Effort
The amount of time and effort put in the business should indicate that you are serious about making a profit on it. If you are working on your business, especially the unenjoyable parts, on a regular basis it indicates you are serious about turning over a profit. If those babies from the broodmares in the above example are getting sold out of the pasture with no real advertising plan or sales plan you probably have a hobby. However, if you have a plan for advertising, fitting, potential sales, etc for those babies and you follow through that leans more towards a business. Think about it, the serious breeding facility down the road has their yearlings fit and in a sales program. They know what they want for each yearling, what sales platform fits them best, and what yearlings they want to keep in their program as investments. They are putting a large amount of time and effort into making a profit off of their breeding program.
The Expertise of the Taxpayer
This one is pretty easy to understand. If you are running a business you are either an expert in the industry, working to become an expert in the industry, you hire an expert to help/advise you, or some combination. Again this shows that you are serious about making money on this activity. A savvy business person doesn't jump into an industry without research, knowledge, and guidance. These are required for success. If you purchase land and decide to plant some vegetables to sell at a local farmers market you should either have experience, learn what to plant and how to care for your crops, or hire someone who knows what they're doing.
Your Assets Will Appreciate Due to Your Activities
This one is a little harder to grasp, but something needs to be gaining value. Either the company's bank account and/or some other asset(s) need to be increasing in value that makes the expenses associated with the business justified. We may be able to tolerate a loss in a business if we will later be able realize a gain on assets in the future. If you realize assets are not increasing in value you should be making changes to facilitate their increase in value. This is something management keeps an eye on in a business environment and is often the driving force behind change.
Prior Success of the Taxpayer
Do you have a history of being successful in other business ventures in the same industry? Or do you have a history of turning failing or unprofitable businesses into profitable ones? If you have turned a business around in the past it is more likely that you are intending to do the same even if a company is currently not profitable. If you have taken a failing farm and made it profitable or if you operate other farms which are obviously businesses than it is easier for the IRS to see that you are in fact in the business of farming.
History of Income/Losses in the Business
The timing of profits and losses in a business are important. If the business is new it is understood the may be a few years of losses before the company becomes profitable. It is also hard to show that an activity is a business even if it is profitable most years, but the amount of losses incurred far outweighs the total profits. A company can make small gains most years, have a few very large losses, therefore a overall historic loss and be considered a hobby even though it is profitable three out of the last five years. This ties into the next concept.
Amount of Occasional Profits
If the profits occur infrequently, but more than make up for the prior losses of the company the business may just have an abnormal cash flow, but it points to a profit motivation. Remember, a hobby does not have profit as a main motivation.
Financial Status of the Taxpayer
Is the taxpayer primarily supporting themselves from the activity or do they have other, much larger sources of income? Is the company providing significant tax benefits for the taxpayer? Again, this points at a profit motivator. If the taxpayer receives little income from the activity and/or a large tax benefit the activity is likely not a business. If the taxpayer relies on the activity to put food on the table and pay bills they're probably motivated by profit.
Enjoyment and Recreation
If the taxpayer does not enjoy the activity it is likely to not be a hobby. Hobbies have other motivating factors besides profit such as enjoyment and recreation. An activity the taxpayer does not like probably has a profit motivator. Fortunately for many of our clients even if you enjoy what you do there activity can still be classified as a business by the IRS it just needs to have other characteristics.
Remember the evaluation of the business looks at all of these characteristics combined. No one characteristic is a definitive deciding factor each time. If you want to establish an activity as a business it is important that profit is a motivating factor and that it is run as a business.
IRS FAQ about business vs hobby distinction