

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.
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."
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.
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.
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Funded, in part, through a Cooperative Agreement with the U.S. Small Business Administration. All opinions, and/or recommendations expressed herein are those of the author(s) and do not necessarily reflect the views of the SBA.