When Does a Hobby Become A Business? By David A. Katzman Many Americans turn their favorite leisure activities into viable enterprises. Passionate cooks start catering businesses. Animal lovers open pet-sitting services. Camera bugs start photography studios. However, if you are thinking about converting a sideline into a commercial venture, be aware of the tax rules around hobbies. If you sustain losses, your business may be considered a hobby and ineligible for tax deductions afforded profitable businesses. Generally, people establish businesses to make a profit. The “hobby-loss” rules are based on the idea that you can only deduct expenses to the extent that your hobby is generating income. From the perspective of tax rules, costs incurred through a hobby could be used by an individual taxpayer to inflate expenses, thereby reducing his or her taxes. So even if you plan for your business to make money, it still has to meet certain criteria for tax purposes to avert the hobby-loss rules. For example, if you operate a dog grooming business out of your house, you can deduct your state and local property taxes, as well as home mortgage interest. However, the amount you can deduct for specifically business-related costs such as ads in the yellow pages, a website, sprayers and other equipment, cannot exceed the amount of income that you report if the IRS were to deem this a hobby. If you earn $20,000 from the dog grooming business in the first year and spend $25,000 on supplies, marketing and other business-related costs, you cannot claim the loss. Business or hobby? If you can demonstrate that your business has been generating profits for three out of five consecutive years, you can avoid the hobby-loss rules. The rules are slightly different for businesses that focus primarily on the breeding, showing, training or racing of horses. In these cases, the activities must make a profit for two of the last seven years. If profits are elusive, you can still mitigate the possibility that the IRS will disallow your business losses by operating your venture in a way that proves you intend to earn a profit. For example, if you are knowledgeable in your field; make an effort to stay abreast of developments by purchasing books, attending related conferences or joining professional groups; keep good financial records; and spend a significant amount of time on the business, you increase the odds that the IRS will view your venture as a serious undertaking. Factors such as your overall financial status and whether you depend on the income from the activity, are also important. If you have enlisted the help of advisors who have the requisite expertise, that will also help your case. If the hobby loss rules apply, you generally may claim your hobby related expenses only as a miscellaneous itemized deduction subject to the 2% limitation.on Schedule A of Form 1040. Consequently, some of your deductions although deductible, may be lost due to the limitation. However, if your new business is separate and apart from any hobby, you could include any normally allowable business expenses on Schedule C, even if they exceeded income from the enterprise, thus giving rise to a deductible loss. Please consult your tax advisor for details and assistance in applying this general information to your specific situation. David A. Katzman is a certified public accountant licensed to practice in the State of Florida and the Commonwealth of Massachusetts. He is also a certified financial planner and certified senior advisor.