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Are you running a small business — or just indulging in an expensive hobby? The answer may depend on what deductions you claim on your income taxes and how the IRS interprets those deductions.

Small business owners can take deductions for all “ordinary and necessary” business expenses, depreciation on business assets they purchase, and losses incurred in the course of business.

The IRS has rules to prevent hobbyists from taking excessive tax deductions.

If your business is an activity that many people enjoy as a hobby – for example, making jewelry, painting oil portraits, or playing in a cover band — and isn't consistently profitable, there can be a fine line between "hobby" and "business."

Know the Rules

The IRS recognizes that it generally takes a few years for startup businesses to become profitable. As long as you made a profit in three of the past five tax years (including the current year), the IRS considers your business a for-profit activity. (If your business is breeding, showing, training, or racing horses, you only have to show a profit in two of the last seven tax years.) If you don't meet those criteria, however, the IRS may decide to audit your business.

If after the audit the IRS rules your operation a hobby, you can still claim certain tax deductions for the costs of your hobby (as long as you itemize them on Schedule A, Form 1040). However, you can only claim a deduction equal to the gross receipts from your hobby. This can be a severe blow for owners of small or part-time businesses who use losses from their businesses to reduce their families' overall tax burden.

What if your business makes a profit in some years, but not in others? The IRS expects to see forward progress—which means a gradual increase in profits. If your business seesaws back and forth between profitability one year and loss the next, you may be in trouble.

However, just because you can't pass the three-out-of-five-years criteria doesn't mean all is lost.

When deciding whether your business is a hobby or not, the IRS also considers these factors:

• Does the time and effort put into the activity show that you intend to make a profit?
• Do you depend on income from the activity for your living?
• Are any losses due to circumstances beyond your control (such as a client not paying you) or did they occur in the startup phase of the business?
• Have you changed methods of operation to improve profitability? (If you keep running your business the same way even though it's clearly not working, the IRS will doubt your intentions.)
• Do you have the knowledge needed to carry on the activity as a successful business? Training, certification, or previous job experience in the field can help show that you are serious about the business.
• Have you made a profit in similar activities in the past?
• Does the activity make a profit in some years?
• Do you expect to make a profit in the future from the appreciation of assets used in the activity?

You can reduce your business's chances of being ruled a hobby by taking the following steps:

• Keep detailed records to support any deductions that you claim on your taxes.
• Set up a separate bank account for your business. Never mingle your personal and business finances (for instance, don't make business purchases from personal accounts, or vice versa).
• Create professional marketing materials, such as business cards and a business website. If you only advertise your business through word-of-mouth or social media, it's likely to look like a hobby.
• Obtain any necessary federal, state, and local licenses and permits for your business, and keep them current. If you sell products, for example, you'll need to get a reseller’s license and remit state sales taxes.
• Write a business plan. Even a simple business plan can help prove that you are trying to make a profit from the activity.
• Consider setting your business up as a corporation, limited liability company (LLC), or partnership. These forms of business can help demonstrate that you plan to generate a profit.

Consult your accountant, tax preparer, and attorney to determine the right steps to take for your business. A SCORE mentor can guide you to the right resources.