An old saying suggests that a business is only a hobby until it is making real money. Or, at a minimum until it stops losing money. For income tax reasons, the IRS is rather concerned about whether your company is a spare time activity. The explanation for this is basic. They don’t want to discover people taking tax deductible losses each year for any activity which is just a tax shelter. If you have a small business that persistently has a loss and it falls into an area of interest that the IRS has considered to be a hobby in the past, you will need to be very careful.

First of all, the organization should be started with the intent of making a profit. Also, you must be ready to prove that you have handled this venture like a business. This requires being well organized by preserving records, separate bank accounts from personal use, and creating a valid plan to generate profit. The Internal Revenue Service will look at other factors which include other types of revenue and whether you handled your organization like a full time job. If you have a deductible loss, you will need to demonstrate that you put in the effort required to do everything possible to make a positive income.

Furthermore, if you’re able to demonstrate that your enterprise has been making money previously, the IRS will be less rigid with you. Past profits are generally proof that the commercial idea was logical and that your negative earnings are practical for income tax reasons.

One more thing that the IRS will probably ask about is what fields have you performed business in the past. For instance, let’s say you began a technology business in Napa Valley which made $50 million when you sold this business. Afterwards you decide to go into semi-retirement mode and buy a big vineyard in the same region. Understanding that it’s difficult to earn money from the wine business, you incur a loss for 3 years consecutively. In such cases, the IRS may identify that you had another source in which you obtained your income. In addition, you had no previous experience with the wine sector. Since you are semi retired, you are not actually employed in the vineyard. On top of that, you’ve got a manager handling the business operations.

Owning a winery might have been a lifelong aspiration that you had. In addition, this a market by which other folks in similar predicaments have gotten into. The IRS is going to take this into account. This niche consists of a great deal of winery owners which have not been reliant on the income with this vineyard. For that reason, the IRS will decide that your venture is a hobby.

In this illustration, the IRS will evaluate the economic history of the business. If a five year period goes by and you generate positive income in 3 of those years, the IRS will allow a business loss. The reason is that the business was profitable the majority of the time in the past five years. Oftentimes, you will find a fine line between hobby versus business losses. Whenever you get in a situation that is questionable, consult with a tax professional.

Eileen Jacobs is an accountant from Las Vegas, NV. She has over 30 years of tax and accounting experience.