It’s a question that needs to be answered for a small business that’s not showing a profit. The IRS has compiled nine factors that can help you determine which of these two categories your business falls within.
1. How does the taxpayer carry on the activity?
Factors like keeping accounting records and maintaining a separate business bank account support the “business” designation. Is the taxpayer conducting the business like other similar profitable entities?
2. What is the taxpayer’s expertise?
The taxpayer should have extensive knowledge of the business, and be able to show that experts have been consulted and acceptable business methods studied.
3. How much time and effort does the taxpayer expend in conducting the business?
Does the taxpayer work in this business only occasionally, or is the effort continuous and substantial compared to other activities (for example, a day job).
4. Is there an expectation that assets used in the business will appreciate in value?
It may be that the asset value increase (e.g., land) would hold more weight than the current profit or loss.
5. What has been the taxpayer’s success in other business activities?
Does the taxpayer have a history of converting unprofitable activities into profitable businesses?
6. What is the history of income or losses from the business?
The rule-of-thumb is that businesses must show a profit in three out of the last five years to avoid the hobby loss rules. However, other factors may influence this “rule,” including businesses that are dependent on a sector of the economy that is experiencing overall declines in profit.
7. What is the relative amount of the profits and losses?
The IRS may also consider the relationship between the amount invested by the taxpayer, and the value of the assets used in the business, to the amounts of profit or loss. This relationship would be considered in determining a taxpayer’s intent to make the activity profitable.
8. What is the taxpayer’s financial status?
Consideration may also be given to the other sources of income available to the taxpayer. If the taxpayer relies heavily on the activity for financial support, the activity is likely to be considered a business.
9. Does the activity provide recreation or involve personal motives?
The IRS does not say that there can be no enjoyment in conducting the business, but it is clear that an activity that seems more recreational than business may indicate lack of a profit motive.
It’s important to note there’s no single conclusive deciding factor when trying to make a determination, and that all facts and circumstances must be considered. Please feel free to contact our office if you have questions about your own situation. We’re happy to help!