This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.
People who start a business as a sideline job are called “second job entrepreneurs” by the Bureau of Labor Statistics. Nobody knows exactly how many people fall into this category, but there are likely millions. Second-job entrepreneurs do so to earn extra money or because they enjoy the work. But a sideline business costs can introduce some difficult tax situations.
If you have a sideline business that’s separate from your job or main business and your expenses exceed the income from your sideline activity, you face a special tax challenge from the IRS under the “hobby loss rule.” This rule limits write-offs from the sideline activity.
While there’s no absolute way to avoid an audit of your sideline activity, there are things you can do to minimize your chances of being selected for audit as well as ensuring a happy outcome if you are audited. Understand what the rule is and what you can do to escape its application to your sideline activity.
The tax law says that if you engage in an activity with no profit motive, it is considered to be a hobby. As such, expenses from the activity in excess of income from the activity cannot be deducted. They are lost and gone forever. There’s more.
The hobby loss rule does not apply if you have a reasonable expectation of making a profit from the activity. Clearly, you don’t have to give a guarantee to the IRS or anyone else that you’ll be successful; in business there are no guarantees. But you can’t operate solely for personal reasons, without regard to financial considerations.
Unfortunately, there’s no bright line for determining whether you have a profit motive. Your word alone isn’t good enough. There are two ways to show the IRS you mean business:
Here are some ways to protect yourself:
If you’re up for some “light reading,” you can view the factors that the IRS uses to determine a profit motive by checking the IRS guide. This is the guide used by IRS auditors for hobby loss challenges. Also work with a CPA or other tax advisor to help you stay off the IRS’ radar or to be successful if the IRS challenges your deductions.
Disclaimer: The links and mentions on this site may be affiliate links. But they do not affect the actual opinions and recommendations of the authors.
Wise Bread is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to amazon.com.