You have a passion for home repairs, and you produce professional products that you are proud of. Friends and neighbors ask for your help, and refer you to their friends. Before you know it, your spare time is filled doing a variety of repair projects for others (and getting paid for it, too!) You are sure you can run a successful home repair business in your town.
After a little thought, it isn’t long before you start posting ads on Craigslist, sharing on Facebook, or passing flyers around. Word of mouth about your service spreads, and you have customers all across town. Congratulations, you started a small business!
But hold on a moment – are you really in business, or are you just making money off your hobby?
The Internal Revenue Service takes a serious look at a hobby listed as a business, and there are rules to determine if your activity qualifies as a business. Here are some factors for you to consider:
Your time spent
Are you spending a few hours per week on your business, or several hours per day? You must be able to show that you are putting in the time needed for your business to make a profit. Otherwise, you are just spending free time on your hobby.
Do you depend on the income?
What would happen if you lost the income from your business? If the income your business generates suddenly stops, could you still pay your bills?
Your business knowledge
Do you have the knowledge to start and operate a successful business? If not, do you trust someone who can be an advisor? Have you successfully operated similar activities in the past?
Profit is the goal of most small businesses. Do you reasonably expect to make a profit from your activity? The IRS considers you ‘for profit’ if you make a profit for at least three of the last five tax years, including this year. If you are not making a profit, are you making changes in your operation to turn this around?
Business Deductions vs. Hobby Deductions
If you are operating a hobby (and earning money from it), you are able to deduct expenses up to the amount you earned from your hobby. You have to report your income from your hobby, but you can also report your expenses.
If you are in business, however, you can deduct the expenses of starting and operating your business, even if you have a loss. How much can you deduct? It depends on your specific situation, but is generally much more than deductions allowed from a hobby.
Here’s an example:
You operate a home repair service (carpentry, painting, plumbing, general home repairs) from your garage and have numerous customers in your area. You have a considerable investment in a truck, tools, and supplies. Customers are happy with your services, and word of mouth drives more customers to you.
As a hobby, you are able to deduct expenses (materials, tools, equipment, etc.) up to the amount you earn from the sales.
As a business, however, you can deduct those expenses, plus:
- The cost of going into business (business license, permits)
- Accountant and legal fees
- A vehicle (or vehicles)
- A deduction for the business use of your home
- The cost of going to industry events, including travel, hotels, meals, and associated fees
- Training, classes, and certifications you might need to remain current
- Membership in the local Chamber of Commerce, Better Business Bureau, and other organizations related to your business
- And so much more
So, how do you show you are a business, an not a hobby?
There is only one way to prove that you are a business and not a hobby – RECORDKEEPING.
Do you have?
- A business plan – The old saying goes “If you fail to plan, you plan to fail.” Businesses that have a business plan (and follow it) are several times more likely to succeed than those who do not have a plan.
- Business Entity Formation – Set up your business as a sole proprietor, partnership, limited liability company, or corporation. Each business form has its advantages and disadvantages, so take some time to choose a form that’s beneficial for you now and in the future.
- Copies of licenses and permits – documents that show you are legally able to sell your product or service.
- Accounting records that show all of your transactions (purchases, sales, expenses) – this includes financial records of prior performance and projections for future operations.
Here are three resources you can turn to for more information:
- Hampton Roads Accounting. We specialize in small businesses, providing a range of services including accounting, bookkeeping, payroll, business planning, and tax services.
- IRS Publication 535, Business Expenses. You can find a copy of this publication in our Resources Section.
- Small Business Administration – In our Resources Section, under ‘Starting a Business’, you will find several courses from the Small Business Administration, including one on creating a business plan.
If you want help, just contact Hampton Roads Accounting today. We’re here to help you succeed.