Many taxpayers work for someone else and receive a W-2 at year-end. Reporting that income (and withholding) is fairly straight-forward each year. For someone who works for themselves and/or receives 1099 income as an independent contractor, proper tax reporting is often much more complex. If self-employed, you may or may not receive forms 1099-MISC or 1099-K from those you provide services to. Even if you don’t receive these forms for a given year, you are required to report your total gross revenue and related expenses to the IRS on your income tax returns.
A choice that a taxpayer must also make when conducting activity as described above is how to classify that activity – as a business or a hobby. Whether your activity is deemed to be a business or hobby, the income must be reported for tax purposes. If it is a business activity, the net income from that business will be subject to income tax and self-employment tax. Hobby income would only be subject to income tax. If it is a business activity that has expenses greater than the revenue generated, a loss can be claimed that will offset any other income reported on the tax return. If it is a hobby, losses can only reduce your net income to zero but can’t produce a deductible loss.
The IRS guidelines regarding this issue are clear: the taxpayer must show a profit motive for conducting the business or any net losses produced will not be allowed. The general rule here is that a taxpayer must show a profit in a minimum of three of the past five tax years. There are other determining factors, however, and I have listed several of them below.
1. Good record keeping, promotion of business.
2. Expectation of business growth.
3. Level of adaptation for business to become profitable.
4. Level of success in past similar business ventures.
5. The ongoing nature of your losses when those losses could have been avoided.
6. The level of time and effort spent on the success of your business.
7. Level of expertise in this business field.
8. Reliance or lack of reliance on business success to sustain lifestyle.
9. Enjoyment level of operating the business activity in spite of consistent losses.
Each of these factors all lead to the same basic principle that the IRS relies on to make decisions in a business versus hobby case – does the business operate like a business and does the owner treat the activity like a legitimate business?
If you do operate what should be classified as a hobby, report that activity as a hobby and not as a business. This may preclude you from claiming a loss from the activity in a given year, but it will also ensure that the IRS will not come knocking to question the validity of the business. Having said that, we at Weech Financial, PLLC will be your advocate and advisor to help you structure your business in the most efficient way possible and keep you on solid ground.
If you have a question regarding your activity and whether it should be classified as a business or hobby, please contact us to discuss.