Turning a hobby into a small business | Part 4 – Tax perks

To celebrate Small Business Month, Jamil Khan, Chief Strategy and Small Business Officer at H&R Block, shares a five-part series that guides future entrepreneurs on what they need to know when transforming their hobby into a small business. Just joining the discussion? Don’t miss the other articles in this series from Jamil.

Block Advisors by H&R Block is honored to support Small Business Owners all year round. Our friendly experts provide affordable tax, bookkeeping, payroll, and business formation expertise and tools year-round, backed up by our Block Advisors guarantees.

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Understand the perks and limitations of small business taxes

Shifting from hobby to business has a few upsides I want to share with you – one of the largest being the valuable ability to deduct business expenses and losses. The IRS allows small businesses to offset their business income by deducting “ordinary and necessary expenses.” Furthermore, if you have a tough year and find yourself with a loss rather than a profit, that loss can be deducted from your current year’s non-business income, or against income in future years.

NOTE: These perks come with a strong caution from my friends at The Tax Institute – if you find yourself reporting high expenses and losses for several years, the IRS may start to question if you truly have a business or if it is a hobby. Thankfully, there are ways to safeguard your small business’ status and ensure you don’t accidentally regress into hobby classification.

First – a little background. Many small business owners use Schedule C when filing their taxes. This document details your company’s profits, losses, and deductions. There are many deductions that are available to small business owners that hobbyists simply don’t have access to. When you’re a small business, a few of the things you can deduct include:

• Home office expenses
• Work-related travel expenses
• Phone and internet expenses
• Work-related vehicle expenses
• Advertising and marketing expenses

The items listed above are just the beginning – what you can deduct if you own a small business is quite extensive. The Block Advisors Resource Center has a great article to learn more about small business deductions.

While it can be advantageous to utilize small business deductions as an entrepreneur, I urge you to keep meticulous records and possess a thorough business plan (more on that next week!). These documents are some of your strongest tools to prove your small business status if the IRS comes knocking on your door. They will help validate your intent to strive for a profitable business today and in the future – a primary requirement to be seen as a small business.

It’s ok to ask for help here. Keeping track of paperwork and files can be a monumental task for a new small business owner. Getting expert guidance and organization assistance, such as through Block Advisors’ year-round tax planning service and monthly small business bookkeeping service, can take the stress of these tasks off your plate so you can focus on revenue-creating work.

As I mentioned above, all these lovely tax deductions are contingent on your small business actually being, well, a small business. That’s where the P-word comes into play. What’s the P-word? It’s PROFIT. That’s right – the best way to show the IRS that you mean business is to seek a profit. If your pursuit isn’t in the business of making money, it is possible the IRS will write it off as a hobby. If you’re curious how the IRS determines that you have a profit-motive for your company, check out The Tax Institute article “What are the factors for determining whether an activity is a for-profit business or a hobby?” Some include:

• Does your livelihood rely on income from this activity? (e.g., you use your income to obtain your rent, food, transportation, etc.)
• Are you trained and knowledgeable in the field your business is in?
• Have you profited from this activity in the past, or expect to in the future?
• Did you spend time and effort in pursuit of a profit?
• If you lost money, was it beyond your control?

The more of the above statements that you can confidently say, “yes” to, the more likely the IRS is going to consider your activity to have a profit motive. If a strong case can be made for your profit motive, you’re more likely to continue to be seen as a business from the IRS’ perspective.

If you’re about to panic because you’ve had a couple of bad years with losses, let me intervene. The IRS is fully aware that sometimes businesses, especially new small businesses, may have periods of time where they are unprofitable. The “safe harbor rule” may ease your mind if you are concerned about your business status coming into question due to losses.

This guideline states that the IRS will assume a true business motive if your company has earned a profit in at least three of the past five years. This gives you a little wiggle room to account for those tough early startup days, times of economic downturn, or simply off years. Still, you naturally want to minimize loss years when possible – after all, profit is a key goal for small businesses.   

The bottom line – document, document, document!

Block Advisors offers many services and products that can help you stay on top of your complex small business needs. Leave your taxes, bookkeeping, and payroll in the hands of our experts. Your business is our business, so you can be confident that it is in good hands. When it comes to tracking small business deductions, you don’t want to miss a single one!

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