Newsletter - December 29, 2010
The Jewelry Crafter
A newsletter for the home jeweler
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Hobby or Business?
By
Mary Harvey
Most people begin their jewelry-making career as a labor of love. They enjoy the challenge and the rewards of creating a one-of-a-kind piece of jewelry. Some sell their pieces and make a profit. But how do you know if your jewelry making is a hobby or a business? What are the advantages and disadvantages of being a business versus a hobby? In this issue, we will explore the IRS definition of business, and how to determine which applies to you.
The IRS defines a hobby as an activity that you engage in without expecting to make a taxable profit. If you make, or intend to make, a profit, the IRS considers you a business. As a business, you are able to deduct expenses directly from your income, where as a hobby, you are not.
A business is allowed to operate at a loss. The IRS has what is called the “hobby loss rule”, or the “3 of 5” rule. You must show that you either made or intended to make a profit in the last 3 of 5 years. If you do not, your activity is considered a hobby, and you cannot deduct your losses from your income.
The IRS takes several factors into account when determining if your activity is for profit:
- Does the time and effort put into the activity indicate an intention to make a profit?
- Do you depend on income from the activity?
- If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
- Have you changed methods of operation to improve profitability?
- Do you have the knowledge needed to carry on the activity as a successful business?
- Have you made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Do you expect to make a profit in the future from the appreciation of assets used in the activity?
Consecutive year losses (the hobby loss rule), is a huge red flag to the IRS, and can trigger an audit. If this happens, you must be able to show the IRS that you are making an attempt to run a legitimate business, and not just trying to claim business tax breaks. The best way to prove this is to run your business like a business – a well maintained set of books (separate from your personal finances), proper business licenses, business cards and letterhead, advertising or other marketing efforts can help persuade the IRS that you are a legitimate business.
It is very important if you are thinking of starting a business, or converting a hobby into a business, that you consult a professional. An accountant, financial planner or business coach will know the current rules, and can save you a lot of headaches down the road.
For more information on setting up your business, see the IRS Website at www.irs.gov, or the Small Business Administration at www.sba.gov, your local SCORE chapter, www.score.org.
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