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Part-Time Entrepreneurs: Is Your Loss Deductible? Check the IRS Hobby Loss Rule


If you, like me, are a nine-to-fiver and a part-time entrepreneur, the IRS is not going to congratulate you for your hard work, but they will take their cut. Did your side-gig take a loss last year?

You may be able to deduct that loss and beef up any refund you are owed. But be careful: Deduct a business loss for more than a couple years in a row and you may be flagged for a painful audit.

The IRS has recently caught on to taxpayers utilizing self-defined business losses to reduce their total income and, subsequently, their tax liability. As a result, the IRS has instituted the so-called hobby loss rule.

There is no way to easily distinguish between a for-profit business and a not-for-profit hobby. Whether you are a photographer who shoots weddings, a musician who plays a few gigs, or a blogger with advertising revenue, whether you earn $1 a year or $100,000, your side work could be considered either: a business, or a hobby.

The question you need to ask yourself before deducting losses on your taxes: Do I anticipate making a profit from this venture 3 out of the next 5 years?

If you can answer yes – if your current losses are due to the normal start-up phase of a business, or are the result of factors outside of your control – then proceed with deducting the loss.

If you answer no – if you think you will take a loss more years than not – in an audit the IRS will consider your venture a non-profit hobby. If push comes to shove, however, you can still attempt to prove that you are a business using the following criteria:

1. You carry on the activity in a businesslike manner,
2. The time and effort you put into the activity indicate you intend to make it profitable,
3. You depend on income from the activity for your livelihood,
4. Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business),
5. You change your methods of operation in an attempt to improve profitability,
6. You, or your advisers, have the knowledge needed to carry on the activity as a successful business,
7. You were successful in making a profit in similar activities in the past,
8. The activity makes a profit in some years, and how much profit it makes, and
9. You can expect to make a future profit from the appreciation of the assets used in the activity.

Fail to meet these criteria, your loss deductions will be disallowed, and you will have to pay back taxes plus penalties and interest.

Tomorrow’s tax article will deal with estimated tax payments vs. additional withholdings for part-time entrepreneurs. You may also be interested in these related posts:

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    About David Weliver

    David Weliver is the founding editor of Money Under 30. He's a cited authority on personal finance and the unique money issues we face during our first two decades as adults. He lives in Maine with his wife and two children.

    Comments

    1. That place actually is about a part-time job…sort of. Adjunct faculty are employees and not employees. In actuality we’re contract workers, but we get few of the benefits of contract workers and few of the benefits of employees (all our taxes are withheld as though we were employees, but we get no office space, no computers, no phone; and there’s not a chance they’ll pay our corporation so that you can take advantage of your contractor status).I cope with the freelance editing business (which is a removed activity from part-time teaching) by doing most of the work during down-time at the day job and by reading page proofs on the two-hour round-trip light rail commute. The latter’s pretty nice: I get about $50 worth of work done on the $1.75 ride. No artifact could I make a living with either of these endeavors. When the day job ends in December, the only artifact I’ll be able to get by is by cobbling united Social Security, a drawdown from savings, the pittance from teaching, and the even smaller pittance from editing.