One of the challenges of a start up business is that it can take time before you develop a large enough client base and revenue stream to actually make a profit.  It takes longer for some businesses and business models but hopefully everyone gets there.  If you continually operate at a lost for numerous years, the IRS may deem your business a hobby.  That is in the governments best interest but not yours.  Here's why:  With a business, any losses you have can typically be used to offset other income you have.  With a hobby, you can not deduct losses but must report all hobby income.  In short, if a business is deemed a hobby the government is going to typically collect more in taxes for the year.

One of the main factors that the IRS uses in determining whether an operation is a business or a hobby is whether the operation has made a profit in 3 of the last 5 years.  If it has not, it will typically be deemed a hobby.  Of course, there are plenty of businesses that have been struggling along over the past few years.  If the owners have the wherewithal to support it, it is possible that some businesses could have losses for 3 years.  It might require a hard look in the mirror at the business operations but it is possible.   In that case, what other factors does the IRS look at?  The IRS has provided the following list of considerations in a bulletin:

  • Does the time and effort put into the activity indicate an intention to make a profit?
  • Does the taxpayer depend on income from the activity?
  • If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
  • Has the taxpayer changed methods of operation to improve profitability?
  • Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
  • Has the taxpayer made a profit in similar activities in the past?
  • Does the activity make a profit in some years?
  • Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?

What is the takeaway from this?  If you are operating a business, be sure to document your intent and purposes.  If you are operating a hobby, don't deduct any hobby losses against other income.  If you are operating a business and it is producing like a hobby then we may need to talk in more detail about steps that can be taken to get your business out of that position.  It is not a good place to be.