Finances of Business vs. Hobby

By Dave Denniston, CFA
Have you ever wondered… is my business a hobby?
You may have heard that having a small business is one of the best tax deductions out there.
But… when is a business a business and when is my ‘business’ a hobby?

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I have many folks that I work with who are passionate about some cool stuff- toy trains and art and music. Heck, my wife is one of those amazing artists. Some of these businesses are actually quite profitable.
They have revenue.
They have expenses.
They have a profit.
The IRS loves those businesses because they can TAX those juicy profits. The gray line becomes when there is NOT a profit.
Maybe there isn’t revenue and there are only expenses. Or the revenue is minimal. What if it’s the latter of those two scenarios? What if this business doesn’t have a profit?
Can I still write it off?
Just because a business doesn’t have a profit YET doesn’t mean that you should toss it away and not take the write-off.
As a matter of fact, there are some cases where you should take a tax loss and it’s perfectly acceptable.
Heck, I even encourage you to pursue having a business as one of my 5 Smart Strategies To Slash Your Taxes in 2017.
Before we carve into the meat of the article, let’s figure out what the IRS says about this.

There are 9 specific questions that the IRS poses to determine whether or not your business is a hobby:

• Does the time and effort put into the activity indicate an intention to make a profit?
• Do you depend on income from the activity?
• If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
• Have you changed methods of operation to improve profitability?
• Do you have the knowledge needed to carry on the activity as a successful business?
• Have you made a profit in similar activities in the past?
• Does the activity make a profit in some years?
• Do you expect to make a profit in the future from the appreciation of assets used in the activity?

So, let’s break this down a little bit.

Question# 1. Does the time and effort put into the activity indicate an intention to make a profit? The key word here is INTENTION.
You need to have documentation that you have INTENTION.
For example, do you have a 1 page business plan? What have you invested into your business? Do you have a website? A Facebook page with active postings? A Twitter account posting your content?
Do you have any products or services? Have you tried to market them?
If you’ve never put any money into marketing the business- for example, you don’t have a website and you’ve never tried advertising and you’ve never tried guest blogging or podcasts- you may have a very difficult time to prove that you intended to make a profit.
Are you just writing off a portion of your house bills or your cell phone or your new computer, but don’t have any activities to point to show that you are INTENDING to make a profit?
Make sure you have documented evidence!
Here’s more from the IRS on this issue…
“An activity is presumed for profit if it makes a profit in at least three of the last five tax years, including the current year (or at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses).”
So, unless you are into horse breeding and raising, you could write off at least 2 years of business losses- but once you get into year three… you really have to think long and hard about your intention to make a profit.
The second question can be a key one for continuing the write-offs…

Question# 2: Do you depend on income from the activity?
Let’s take a look at a couple of examples.
One physician I work with is an expert witness. He does this ‘on the side’. He makes substantial income- 100k+ a year from this activity in addition to his work at an academic hospital.
He depends on this activity to help save for retirement, pay off his mortgage, etc. So, in this case, he is dependent on the income.
He could take a year off and only make $10k from this business and still do some write-offs.
Definitely a business and not a hobby. There’s a history of profits here.

Another client I work with is the spouse of a high-earning client. The primary bread winner makes $300k to $500k a year. His spouse has an incredible heart. She takes old ties and turns them into pieces of art. She sells them at craft show and often donates half the proceeds to charitable causes.
In this case, there’s still a cost of supplies- quite often the business produces a loss.
She doesn’t advertise. She does it on the side and doesn’t really care whether or not she makes a profit. Some years she makes $2k or $5k. Other years she might lose a few hundred dollars.
This is a case that’s right on the edge.
There is revenue. There are expenses.
However, it’s not their main source of income. Heck, it’s so relatively small, it’s really unnecessary. 
Some CPAs would call this a ‘hobby’. Others might call it a write-off.
If you have a similar side-hustle to this case, it could depend on how aggressive you want to be with your taxes. You do stand a good chance that the write-off could be disallowed if you get audited. However, it might be okay too.
Just remember… you have two years! So, there’s some runway to get your business to lift off.

Question# 3: If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
This gives you some grace in a really bad year or if you are just getting started.
There is NOTHING wrong with taking a write-off when you are launching a business. You may not yet have revenues or they may be very meager.
There is also NOTHING wrong with having a bad year and taking a fat write-off in the process.
The problem is when you never ever, never ever make a profit and it doesn’t appear to be anywhere on the horizon after 2 years.
You can always launch and try a new business after those 2 years and take another write-off.
=-)
Although, after a while… you might wonder if your money was better invested elsewhere.

Question# 4: Have you changed methods of operation to improve profitability?
The IRS is also willing to give you a pass if you are trying to do something different.
For example, let’s say that you had a podcast and it wasn’t generating any revenue after 1 year. You would be perfectly in your right to write off the losses.
Let’s say you generated a little bit of revenue, but had losses in year 2. You’re making progress, but you aren’t there yet. That should be fine to write-off too.
Then, in year 3, you change the way you do things. You start sending e-mails to prospective advertisers and you try to find some affiliate deals. You even make some arrangements and put advertisements in your podcast. You write a new book and try to sell the book on your podcast.
In this case, you have documentation in the forms of e-mails, podcasts, and other ways to demonstrate that in fact you changed your operations to improve profitability.
Remember how important documentation is in everything related to the IRS.
Final Thoughts
There are so many amazing opportunities in the world today. You can sell courses on everything from podcasting to land flipping to painting toy trains to underwater basketweaving.
You can seek plenty opportunities outside of clinical medicine.
Pursue them! Go after them!
You can even write them off for a couple of years and who knows, maybe that side-hustle income can skyrocket and even go way beyond the salary of your clinical career.
More Advice by Dave Denniston- The New Retirement and Does Stuff Own You?
For some more tax-saving ideas, make sure to check out 3 Answers to The Tax Questions Physicians Have Been Asking and The Little Tax Secret for Physicians.

About the Author
Dave Denniston, Chartered Financial Analyst (CFA), is an author and authority for physicians providing a voice and an advocate for all of the financial issues that doctors deal with. He also has 1 wife, 2 kids, and a bunny named Black Snow (which is a lot better of a name than Yellow Snow).
More Advice by Dave Denniston- Does Stuff Own You? and The New Retirement