Hobby or Business? The IRS will need to know.

The years following the recession, which started in December of 2007, were tough times for many. Many laid-off employees who had difficulty finding re-employment began working for themselves. From flipping their business wardrobes, to selling at a local farmer’s market, to pet walking, to driving for a living — all of these gigs are viable businesses with the right plan.

When is your hobby a profit making venture? The Hobby Loss rule

According to the IRS, if a business is presumed to be for profit — it makes a profit in at least three of the last five tax years. The taxpayer cannot deduct losses from doing an activity purely for pleasure, in the same way as if the activity was a business – and incurred a loss. For new business, the IRS expects you to turn a profit in at least three of five years or it will consider your business a hobby. That means if you start a business in year one and lose (expenses exceeded income) some money in years one and two, by year three you should be starting to turn a profit and must declare a profit in years 3, 4, and 5.

The IRS has written a special set of tax instructions: Section 183, which is often called the Hobby Loss section which discusses drawing the line on deductions for “Activities Not Engaged in for Profit.”

Simply put – that means “taxpayers may deduct ordinary and necessary expenses for conducting a trade or business or for the production of income” (if the venture has made a profit in the last 3 out of 5 years), but cannot take deductions if the deductions exceed gross receipts and the activity has not made a profit in the last 3 out of 5 years. There are some allowable deductions for hobby activities, but they have to be taken in a particular order and itemized on Schedule A of your 1040, according to the IRS. Read more on whether your activity is considered a hobby, here.

If you are considering spring-boarding your weekend hobby into a full time job, before you do, consider this:

Accounting, Marketing and Time Management

When was the last time you sat down and did a spreadsheet on your living and working expenses? If that is not something you can easily do – be prepared to hire an accountant and build the cost into your business plan. You may want to find a few and have a discussion about what it will cost to get your venture launched and stay on top of your bills. Then when you decide whether or not you can do it yourself– add in the expense of hired help, to your spreadsheet or ask how you are going to dedicate the time to do this simple task.

Who is going to sell your wares? Freelance anything requires marketing savvy. You have to sell your expertise or product. Ask yourself: is this a skill you are good at?

How are you with deadlines? Having them at your “regular” job is one thing. If you miss one, you (might) still have a paycheck. Having one when you are your own boss is entirely another problem.

If none of this has put you off, then go ahead and develop a plan which should help you to determine if you have a business or a hobby. This means researching and understanding your hobby turned product as a business.