In order to qualify as a business for tax purposes, an activity must be actively engaged in for profit. To determine if a taxpayer has a profit motive, the IRS looks at various factors which are often subject to judgment. It is important for a taxpayer to be able to prove they are a business, as the tax treatment is much more favorable.
If an activity is a business activity, expenses will be deductible and losses may be used to offset other income. The taxpayer can also deduct health insurance premiums and one-half of self employment tax to arrive at adjusted gross income. There will be self-employment tax paid on the earnings, but if the activity generated a loss, self-employment tax is not a factor.
If an activity is considered to be a hobby, the income will be treated as ordinary income. However, the expenses are only deductible as miscellaneous itemized deductions subject to a 2% AGI floor. In addition, any expenses in excess of the income are not deductible and will be permanently lost.
If a taxpayer truly has a profit motive, they should be sure to adequately document their business activity. The activity should have its own accounting records, including an income statement and balance sheet. The activity should have a separate bank account as the taxpayer should not co-mingle personal and business activity funds. In summary, the activity should be ran and operated the same as any other professional business.
If you have any additional questions, please contact Rebecca Bischoff, CPA at 314.576.1350 or firstname.lastname@example.org.