Do you have a side gig apart from your main source of income?
From this sideline gig, do you claim tax losses on your personal tax return?
The IRS likes to claim that money-losing sideline activities are hobbies rather than businesses. And you know what? You can’t deduct hobby losses on your form 1040. Below I will explain how to ensure that your sideline gig qualifies as business and therefore make your losses deductible.
Here’s the deal: if you can show a profit motive for your now-money-losing sideline gig, you can classify that activity as a business on your tax return and deduct your expenses.
Here are factors that prove profit-making intent:
- Maintain accurate accounting records and constantly look for ways to boost profits. Run your sideline gig as an actual business!
- Make yourself an expert in the field or employ others with experience.
- Anticipate appreciation of business assets. For example, the IRS never claims that rental real estate is a hobby despite the fact there are losses every year. The IRS knows that real estate tends to appreciate.
- Spend good amount of time on your activity. This will convince the IRS that you are committed. And your sideline gig it’s an actual business and not a hobby.
- Be successful with other undertakings. This is an indication that you have brilliant business sense.
- Evaluate your past income and losses from the activity. The IRS gives more weight to the intermittent huge profits as opposed to recurrent smaller profits. Losses that occur due to bad lack or an unusual set of events are more justified than constant losses that hobbyists are okay with.
- Take an overlook of your financial status. Ordinary folks typically work toward making money (indication of business) while more affluent individuals can withstand losses (indication of hobby).
- Conside the personal pleasure component. The IRS may consider a fun activity as a hobby compared to something seen as a must-do for income. (breeding horses (hobby) vs. building houses (job))
Example: For-Profit Auto Restoration Business
In 2016 a taxpayer (successful attorney in real life) was restoring Plymouth vehicles as a side hustle. He took care of all business-related chores – advertising, sales, inventory maintenance, etc.
The taxpayer deducted an array of restoration business expenses on his federal income tax return. The IRS audited the taxpayer and rejected the deductions based on the premise it was not a profit-making activity and viewed more as a hobby.
The taxpayer would have had been hit with paying:
- $5,442 in accuracy-related penalties.
- $6,802 of addition to tax
- $27,208 in past taxes
Being a good layer, he took the IRS to the tax court and the court sided with the taxpayer against the IRS, saying the following:
While the taxpayer had an ingenious way of doing business, it was still businesslike. He knew how to run a business and was knowledgeable in Plymouths, advertising in print, online, or events. He traveled outside his state to attain bargain-priced vehicles and reached out to third-party entities to manufacture parts he could resell or use in his restoration projects. When necessary, he’d abandoned activities that made him no profit.
The court noted the taxpayer’s fundamental purpose was to make money; hence, his “hobby” was actually a business. The Taxpayer won his case!
What does this case mean? Simply put:
- Hobby designation is not good for tax health.
- Business designation (where there is provable loss of money) is seen as good for tax health.
If you’re unsure if your venture qualifies as a business or a hobby, the factors above can help you make the determination. For decades, the IRS has been pressing the business vs. hobby subject, and if you get audited, you want to make sure to have all your facts and documentation to prove that your business is a business and not a hobby.