First of all, let’s all talk about why this is important. Back with the Tax Cuts and Jobs Act of 2017 (Trump Tax Plan) effective with 1/1/2018, there was a big change made to what are called hobby businesses. But to understand why this is important, we need to go back even further.
The IRS has long held that hobbies could not create a loss that could be used to offset other income. So if you sold $1,000 worth of crafts and it was just for fun, you could subtract your supplies and other expenses, but only up to $1,000. You couldn’t have any more deductions.
The way you took that deduction was through the “miscellaneous deduction” on your tax return.
You couldn’t take more deduction than your income, so in this case, you’d be limited to $1,000. But you could (and generally would) take a deduction for the total amount of $1,000. So there was no taxable profit.
Trump Tax Plan Means Hobbyists Pay More Taxes
Then in 2018, the ability to take the expenses went away. Effective in 2018, you would have had to report the whole $1,000 as income. You can’t take any deductions.
And most hobbyists just ignored the issue and didn’t report anything.
American Recovery Plan Makes it Worse for Hobbyists in 2021
Now we have a new problem. The American Recovery Plan (ARP) that was passed into law March 2021. Part of it requires companies like eBay, Etsy, Amazon and Merchant Service Providers like Square, Clover and the like to report any seller who has gross sales of $600 or more in a year. That will be reported on a Form 1099-K.
Suddenly, everyone has to report it on their tax return. If it’s a hobby, there is no way to take deductions, so it’ll all be taxable.
If it’s a business, you get all the legitimate business deductions.
It’s Never Been More Important to Have a Business.
The IRS has a 9 factor test that they use to determine whether you have a true business that lets you take deductions or not.
If you pass the test, you get to take deductions against the income you make from selling things. If you don’t pass the test, you pay tax on ALL of the income, without any deductions.
The 9 Factors of the IRS Business Test
There are 9 factors that the IRS lays out for determining whether you have a business or not. You don’t need to pass each of the factors. There is no bright line test. It’s more a case of whether your business appears to pass most of them.
Factor #1: The IRs will want to know whether you carry on the activity in a businesslike manner. Remember the decision is not based on one factor alone. You must consider all factors to establish that an activity is a business engaged in making a profit.
This means you should have a separate checking account for your business, keep track of your income and expenses with a software program like QuickBooks, keep other record and, ideally, have a business structure like an LLC or LLC electing to be taxed like an S Corporation for the business.
Factor #2: The time and effort you put into the activity must indicate you intend to make it profitable. If it’s your full time business, this is easier to prove. If you’re doing it on the side while you still have a day job, you need to show that you are putting in enough time and effort to make a difference. For example, the IRS has said that a case where a couple worked 2 weekends a month and several evenings each week was enough to prove they were diligent about working in their business.
Factor #3: You depend on the income from the activity for your livelihood. This is a tougher one to prove if you’ve been running losses from your business since the beginning. It may be the one you can’t prove.
Factor #4: The losses are due to circumstances beyond your control or are normal in the startup phase of your type of business. Factor #4 goes along with the previous one. If you have a loss that continues, is there a reason that’s reasonable as to why that is occurring? Be prepared for this question.
Factor #5: If you have losses, are you doing something about it? Are you changing your methods or strategies to improve profitability? (Or at least attempt to improve profitability.)
Factor #6: Does your advisor have the knowledge needed to run a successful business? This may very well be the secret factor. Even if you have losses, if you can show you have a CPA, coach or advisor who has successful experience that you regularly work with, you can possibly win this by demonstrating you’re trying. Remember if you have an online business, that CPA, coach or advisor must have online business success.
Factor #7: Did you have financial success in the past with similar activities? This doesn’t necessarily mean that this company made money but that you had a similar company that did. If this is your first time with such a business or if you’ve never had a success before, then it’s more important than ever to use Factor #6.
Factor #8: Did your business make a profit in the past? That’s probably the easiest way to pass the test. If you had net income in the past and expect it in the future, your loss is more understandable.
Factor #9: Will you make a future profit from the sale of assets in your activity? This is the factor that most Internet start-ups use to show year after year of loss. At some point, they hope, they will sell stock in their company, licensing rights or just sell the company outright to a giant and will be rolling in the dough.
If you don’t have a business, you have a hobby. That means you won’t get the SBA grants or loans. That means you won’t get the tax breaks. This is an important test to pass.
Once you have a business, you have opportunities for tax planning you never will have as an employee with a hobby.
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