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Do You Have a Business or Just a Hobby?

When it comes to taxes, knowing the difference could mean the difference between complying with the law--or breaking it.

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If you're making at whatever you do, the really doesn't care if it's a hobby or a . They want their money. "Gross income," as the IRS defines it, includes income "from whatever source derived." So let's say you're a coin collector. You sold two on last year just to get them out of your collection, and you made $100 profit doing so. You should report the $100 as income on your tax return this year.

The "business vs. hobby" distinction truly comes into play when you lose money. So, in my example above, if you lost $100 when you sold the two coins on eBay, the IRS wouldn't let you deduct the $100 against your income from other sources, such as your day job. You can only deduct "hobby losses" against gains from the same hobby. So if this year you sell five coins on eBay, making a $200 profit on two of the coins and a $200 loss on the other three, you can "net" the loss against the profit and report zero income from your hobby.

A professional coin dealer doesn't have to worry about this because he or she is clearly engaged in a business. How do you tell the difference, especially when the business involves buying and selling stuff, something that many people do as a hobby--such as selling coins or antiques on eBay; breeding cats, dogs or other animals; making arts and crafts for sale at craft shows; publishing a newsletter; participating in various kinds of home party sales where your main objective is to get discounts on the products; and other activities where your primary objective is personal satisfaction rather than economic gain.

Under a long-standing IRS rule, you're considered a "business" if you made a profit in three of the past five years, including the current year. But what if you are just starting out and are likely to lose money this year?

Don't lose hope. You may still be considered a "business" for tax purposes if you can prove to the IRS that you're taking your activities seriously and are treating them as a business with the primary goal of making a profit . . . eventually.

So what sorts of things do you need to do? At a minimum, you should have a name for your business, some stationery, invoices, a separate bank account, separate books and records, a place in your home that's used only for this business activity, and some records to show that you're spending some time working on this activity on a regular basis. For example, if you're a coin collector turned coin dealer, you should keep thorough accounts and records, advertise in hobby publications, attend coin shows regularly in your area, and consider forming a corporation or to run the business.

You should also consider preparing a formal business plan showing your projected income and expenses over a five- or ten-year period--with some profit at the end of that period. It would also help if you could show that you're actively studying and learning how to be financially successful in your business. Attending seminars, subscribing to trade magazines or newsletters, buying (and reading) books about the business and consulting with various professionals will also help.

Oh, and try not to look as if you're having too much fun. If the IRS audits your business, and the walls of your home office are covered with rock concert posters, you're toast. Unless, of course, you're dealing in vintage rock posters.

Cliff Ennico is a syndicated columnist, author and host of the PBS television series MoneyHunt. This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. Copyright 2005 Clifford R. Ennico. Distributed by Creators Syndicate Inc.

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