Many small businesses start with an interest that’s a hobby. Then it starts bringing in a little money. Then it makes a profit. But not all hobbies are destined to be businesses.
And the current tax law has put hobbies that generate money — but aren’t profitable — under more scrutiny.
Part of how a hobby becomes a business is by being treated like a business. That includes keeping good financial records as well as putting in reasonable time and effort to make a profit. The concept of profitability is pretty simple. At its core, it’s making more income than is spent on business expenses.
It’s not unusual for people to start a business in which they don’t have a lot of expertise. Having experience in an industry before starting a business can add to the credibility that it’s intended to be a viable profit-making enterprise. Having experienced advisers who can advise on making a profit in an area can also support the idea that a business is intended to be profitable. If the business owner depends on the business for livelihood, that indicates that the entrepreneur intends to make money.
Willingness to make changes in the business to work toward profitability is important. Sometimes, the appreciation of business assets will be a future source of income, which also contributes to the objective to make money.
It’s not unusual for a new business to spend more money on business expenses than the income generated. Even well-established businesses might have years that lose money. That could be due to economic conditions, the cost of growth or staff expansion. For many years, there has been a rule of thumb involving profit. If there has been a profit generated three years in a five-year period, it’s a bit easier to justify that there is an intention to make a profit.
Under current tax law, if an activity is a hobby but has money coming in but doesn’t make a profit, the income has to be reported, but expenses cannot be claimed. If you’re wondering about the logic behind this result, don’t bother. Like many laws, including tax regulations, we don’t have to agree with a law to be subject to it. If, on a regular basis, your hobby makes a profit, then discuss with your tax preparer whether you can report the activity as a business.
If you continue to get money from your hobby but not enough to be profitable, you’re still coming out ahead financially paying tax on it. If you’d still enjoy the hobby without getting any money from it, keep doing it. If you get some money from it, report the income and pay the tax. We’re not subject to 100% tax, so you’re still doing something you enjoy and getting some money from it in the process. And if you want to turn it into a true business, you can make some changes to do that.
Linda Leitz is a certified financial planner and can be reached at email@example.com.