Spotlight: Reader Q & A

In a previous reader Q&A we’ve covered what to do to find your accountant for your SB and get yourself all set up. This time, we’re covering another Q&A from a slightly different angle.

Hi Sarah, I love your site! I’ve been running my business for a little while, but I guess I’ve been treating it more as a hobby than I have a real business. What do I need to do to transition from hobby to bona fide business?

– Reese

Great question, Reese! The simplest answer is to keep track of your income and your expenses, with as much detail as you can, but before we dig into that I want to go right to the source – the IRS.

The IRS is slowly becoming more and more modernized, and has a great Help & Resources Section of their website. Here’s what they say about distinguishing between a business and a hobby. The thing to pay attention from there is that there are nine important factors that help make the distinction between a hobby and a business:

  • Whether you carry on the activity in a businesslike manner.
  • Whether the time and effort you put into the activity indicate you intend to make it profitable.
  • Whether you depend on income from the activity for your livelihood.
  • Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
  • Whether you change your methods of operation in an attempt to improve profitability.
  • Whether you or your advisors have the knowledge needed to carry on the activity as a successful business.
  • Whether you were successful in making a profit in similar activities in the past.
  • Whether the activity makes a profit in some years and how much profit it makes.
  • Whether you can expect to make a future profit from the appreciation of the assets used in the activity.

I also want to share with you a resource from BankRate.com that also breaks down business vs hobby and what the IRS is looking for:

The IRS uses two tests in determining whether your activity is a business or a hobby.

First, the profit test demands that you show you earned money on the activity in three out of five years.

If you can’t meet the profit test, you get another chance to convince the IRS that you are running a business by passing the factors-and-circumstance test. Here, the tax agency takes a subjective, individualized look at your pursuit.

– Whether you carry on the activity in a businesslike manner. This includes, for example, keeping good books and records, promoting your business and holding down costs where possible.

– How much time and effort you devote to the enterprise.

– Whether you depend on income from the activity for your livelihood.

– If your losses are due to circumstances beyond your control or are normal for a business in its startup phase.

– Whether you change your methods of operation in an attempt to improve profitability.

– The knowledge and background you (or your advisers) have in running such a business.

– If you were successful in making a profit in similar activities in the past.

– Whether the activity makes a profit in some years and, if so, how much.

– Whether you can expect to make a future profit from the appreciation of the assets used in the activity.

– The element of personal pleasure involved in the activity. That doesn’t mean you can’t enjoy your new business, but you better be getting more out of it than just a good time.

If you’re not quite sure what can and can’t be deducted as a business (or even hobby) expense, further information can be found right on the IRS’s website in Publication 535.

So let’s get back to your original question: transitioning from a hobby to a real business. As I stated at the beginning, keeping track of your income and expenses is the first place to start. You want to be able to demonstrate to the IRS that you are expecting to make money from this venture, that you’re not just doing it because you love to do it. To that end, get a separate bank account for all of your expenses and income. Having a separate business bank account will further demonstrate that this venture is beyond your hobbying interests. It will also make your bookkeeping a lot easier, and it will safeguard you against any future audit you may have.

In addition to those basics, consider writing a business plan and show how you’d like to grow your profit over the next 3, 6, 9 and 12 months. If you’ve kept track of how much you’ve made (especially after any expenses) while you were working this as a hobby, include that information, too, because it shows the historical background and context for launching your business.

Of course, if you need to have any business licenses or permits in order to do your business, make sure you’ve got all of your bases covered on that end, too.

Hope this helps answer your question, Reese! As always, if you have a burning question about bookkeeping, accounting, or entrepreneurship, send them my way!

(For all of you other entrepreneurs out there, here is an incredibly in-depth resource from Bplans.com for thinking about turning your hobby into a business, and some important questions you need to consider for yourself, as well. The IRS has further reading on deductions as it relates to a business vs. a hobby. Check those out, consider what we’ve discussed here, and let me know how it goes!)

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