As a small business owner, if you have an unfruitful year, you’ll find yourself choosing how to file your loss when it exceeds your income. You might choose to carry the business losses forward over a span of 20 years, or alternatively, carry those losses back for the past two years, to receive a federal and/or state tax refund.
However, you might run into the quandary of the IRS treating your business as a hobby. Should this occur, and the IRS deems your small business as a hobby, you don’t have the carryback or carryforward options. Rather, you can only deduct your loss from your income.
Generally, as a small business, you’re considered as engaging in business when you show a profit for a length of 3+ years (over the duration of a 5-year period). Despite this, and your best efforts as a hard-working owner, you might still incur losses in some years. So how does one mitigate these losses from a tax write off perspective, and not be deemed a hobby?
First, make sure you’re demonstrating that your small business objective is to turn a profit! Then utilize these qualifiers, which are often used by courts in making the distinction between hobby/business:
- Put research into your business venture.
- Create a business plan, as well as, projections.
- Show that you have prior business experiences in the business which you now run.
- Make your business profitable—give it your time, effort, and attention.
- As you grow, take your history of income and loss, and use it as an analytical tool to improve how you operate, so you can increase profits.
- Be professional—conduct your small business activities like a true business! Even model your activities like comparable businesses that show profits.
- Make your business your day job! You should depend on your business income for your livelihood.
Note that the IRS particularly scrutinizes some activities, and these are more often subjected to being deemed as hobbies. (Examples: stamp and antique collecting, auto racing, raising show animals, ministerial duties, creative endeavors such as writing and music recording, etc.)