Business or hobby? Nine factors help the IRS decide

The dividing line between a business and a hobby may be thin, but it can look like a canyon when you are on one side and your tax deductions are on the other. The gap is a function of differing treatment of expenses. For example, when you incur ordinary and necessary expenses in the operation of your business, those costs reduce the taxable income of the business. In addition, business losses can generally be used to offset income from other sources, such as wages.

When your activity is considered a hobby, expenses can only be claimed to the extent of income from the activity, and are generally deductible as a miscellaneous itemized deduction on your personal return.

Here are nine ways to help convince the IRS that you have a business rather than a hobby.

1. Act like a business. Keep accurate books, adopt new techniques, and adjust your operating methods to improve profitability. Other good moves: advertising, purchasing insurance, and maintaining a bank account used only for the activity.
2. Expand your expertise. The key here is to increase your knowledge of the economic aspects of your business. Seek relevant advice from experts on an ongoing basis.
3. Expend time and effort. Focus your energy on the business to show profit intention. Hiring competent managers also indicates your intention to operate as a business.
4. Invest in appreciating assets. A reasonable expectation that property you purchase will increase in value and help create an overall gain can show profit motive.
5. Create a record of success. Have you run other businesses successfully, whether or not related to the present activity?
6. Establish a history of income. No need to be nervous if your startup loses money the first year or two, or if losses in later years are the result of events that are out of your control, such as natural disasters. The general rule for proving your intention to operate a business is to make a profit in three of the last five years.
7. Show a profit. No set amount of profit establishes business intent. Instead, compare the profit you have the opportunity to earn to the losses you may incur and the amount of your investment.
8. Check financing. How are you financing the business? Do you have substantial income from other sources? Does the activity generate losses that provide tax benefits you might not otherwise enjoy?
9. Limit the fun factor. Liking what you do does not necessarily turn a business into a hobby. However, substantial "recreational" aspects can lend weight to classification of your activity as a hobby.

Remember, no one factor is controlling. Instead, you need a pattern that establishes your intention to make a profit.