As I look for ways to save my clients from paying AMT, one thing is becoming clear: starting a business is the way to go! The question is … what hobbies do you love, that could be turned into a business?
A true business exists to make a profit. A hobby is something you enjoy doing, without an expectation of making a profit.
A true business is usually incorporated or formally organized, and has established systems in place to manage work flow, product production, and administrative aspects like bookkeeping. Real businesses prepare proper financial statements, use separate bank accounts, and keep full and accurate records.
A hobby business, on the other hand, may be something you do to make a little extra money, but it doesn’t necessarily exist to make a profit. Crafting, or guiding people on hikes or fishing expeditions, could easily be hobby businesses. In both cases you are doing something that you enjoy and would be doing in any event. You don’t keep any special records, and probably don’t have any special bookkeeping procedures in place. The money you make gets deposited into your personal account, and you spend your own money on supplies and things you need to carry out your hobby. You don’t prepare financial statements, and simply declare the extra income on your tax return.
From a tax perspective, a real business is FAR better. For example, a real, properly incorporated business has hundreds of tax credits and tax deductions available to it. Not so an unincorporated hobby business. A real business can have losses that exceed its income – and those losses can be carried forward for several years. This is a great way to offset income you are making in a regular job, or through real estate investments! It’s also a great way to move income out of the personal side and into the business side.
A hobby business, on the other hand, can’t do any of those things. That’s because the IRS won’t allow a hobby business to deduct anything over and above the income you made with that hobby business. So, the best you can do is break even. If you’re trying to reduce your income to stay away from AMT, hobby income won’t help you – in fact it may even put you more firmly into the AMT trap.