February 20, 2015 by Aaron Scott Young
I’ve had the privilege of speaking with people all over the country. Some people have been in business for years and some are trying to decide if they are ready to make the leap to start their own business.
Of course starting a business is not for everyone, but if you want to take control of your financial future then being your own boss is the quickest way to get there.
Now, not everybody can make that leap of faith immediately from a regular nine-to-five job. But if you at least get something started, on the side, in the evenings or let your creativity start to flow and organize yourself properly into a corporation, or a limited liability company, you will immediately begin to reap the benefits of a pretax life.
In fact, a lot of small businesses start out as a hobby. It’s a perfect transition for most people. I mean, if you are going to put the time and effort into running a business, it might as well be something you love. You find a passion for something you like to do and you decide to see if you can make some money doing it.
Most people, when they are just starting out, will continue to work their day job and focus on their business in the evenings and on the weekends.
Until you can see if your idea has legs, you might as well get a steady paycheck right? Not to mention, you can deduct the cost of running your own business. It’s the perfect scenario. As an employee, you receive very limited deductions, but as a business owner, you can deduct all reasonable and necessary expenses that go along with running a business. How great is that? But before you play both sides of the fence, you need to make sure you understand the rules of business.
Knowing how the IRS classifies business vs. hobby plays a major role in how you will be taxed. If the IRS reclassified your business as a hobby, you could be stuck with a hefty tax bill. All those items you deducted would be disallowed and, in most cases, with a penalty.
If you look like a business, if you act like a business and you behave like a business, then you might just be a business. But beware. If you aren’t following the rules and you get classified as a hobby, you have just eliminated all the deductions that go along with business ownership.
The IRS keeps a close eye on small businesses that are walking the line of being a hobby. If you are getting ready to turn your hobby into a business, make sure you are meeting the basic requirements to be classified as a business.
1.) Are you doing what you are doing to make a profit? The IRS is looking to see if you’ve shown a profit in three of the five years you’ve been in business. Don’t panic if you haven’t shown a profit. Getting a business off the ground is tough and you might not be in a position to produce a profit just yet. You want to be able to show that you are making every reasonable effort. Do you have a business plan or do you have a marketing plan? Can you show that you are doing everything you can to run a successful business?
2.) How much time do you spend on your business? Do you work consistently on your business? If you only work an hour here and an hour there, that doesn’t justify being classified as a business, and it definitely doesn’t show your drive to earn a profit. You need to show that you work a regular schedule. This especially holds true if you are an employee for somebody else and you are working on your business on the side. Make sure you are documenting your hours and schedule.
3.) Do you document your business transactions? Are you using a recordkeeping system dedicated to the business? Do you keep a separate checking account for your business? Play it safe. When in doubt about recordkeeping, over document.
4.) Do you know what you are doing? Do you have the knowledge to be successful at your business? This might seem like a silly requirement, but the IRS wants to know that either you or someone you are working with has knowledge of the industry you have chosen. If you are going to open up a muffin shop, but you’ve never baked a muffin or have any intention of hiring a baker, then you might look a little suspicious.
5.) Do you act like a business owner? Do you have business cards, a business telephone number and website? Have you structured your business in a corporation or limited liability company to add to your credibility? The question is, do you have the structure in place to be a “real” business? This isn’t just a requirement of the IRS, but really for any vendor or client who would do business with you.
6.) Are you licensed for business? Have you obtained the local, county or state licensing to be in business? Can you show proof of your licensing? If you aren’t sure what your county requires, simply go on-line and do some research.
If the IRS can show that you are taking regular business deductions but they have deemed you to be a hobby, you will be required to pay back taxes on any business deductions you claimed. This can be a painful experience, especially if a few years have gone by and the IRS finally catches up to you; penalties plus interest – ouch.
If you are planning to turn your hobby into a business, congratulations! Just make sure you document, document, document…in order to defend your standing as a legitimate business.
If you are already in business but haven’t formed a corporation or LLC, then now is the time. In fact you can form a company today, not pay for 90 days and get a tax deduction.