Starting a company is often touted as a strategy to save on taxes, but how effective is it? As a financial planner, I frequently encounter clients asking, "Can I start a company to save on taxes?" My response typically begins with, "What type of business are you planning to start?" Often, the reply is, "I don’t really have a business, but I heard that I can allocate some household expenses to the company."
To this, I must clarify: The IRS is not easily deceived. If a company reports no income and is loaded with personal expenses and losses, it is unlikely the IRS will consider it a legitimate business.
Clients often follow up with, "I have some income; can I deduct expenses?" This question brings us to the IRS's "Hobby Loss Rule," which clearly distinguishes between a hobby and a business. The tax implications for each are significantly different.
The IRS evaluates 11 factors to determine whether an activity is a hobby or a business:
- Whether the taxpayer carries out the activity in a businesslike manner and maintains complete and accurate books and records.
- Whether the taxpayer puts time and effort into the activity with the intent to make it profitable.
- Whether the taxpayer depends on income from the activity for their livelihood.
- Whether the taxpayer has personal motives for carrying out the activity, such as general enjoyment or relaxation.
- Whether the taxpayer has sufficient income from other sources to fund the activity.
- Whether losses are due to circumstances beyond the taxpayer's control or are typical for the startup phase of a business.
- Whether the taxpayer changes methods of operation to improve profitability.
- Whether the taxpayer and their advisors possess the knowledge necessary to run the activity as a successful business.
- Whether the taxpayer has successfully made a profit in similar activities in the past.
- Whether the activity generates a profit in some years and the amount of profit generated.
- Whether the taxpayer can expect to make a future profit from the appreciation of assets used in the activity.
Source: https://www.irs.gov/newsroom/heres-how-to-tell-the-difference-between-a-hobby-and-a-business-for-tax-purposes
The IRS maintains the final say in determining whether an activity is classified as a business or a hobby. If an activity is deemed a hobby, it carries specific tax consequences:
- Losses from hobbies cannot be used to offset other income.
- Hobby-related expenses are considered Miscellaneous Itemized Deductions on Schedule A.
- Under the Trump tax reform, all miscellaneous itemized deductions (subject to the 2% floor) are disallowed until at least the end of 2025, rendering these deductions ineffective.
In summary, the tax treatment for hobbies is harsh: no deductions are allowed, and all gross receipts are taxed as income.
Is it possible to transform a "hobby" into a "business"? The short answer is "yes," but it requires deliberate planning and execution. First, you must genuinely aim to run a profitable business. Second, thorough planning and meticulous documentation are essential. As the saying goes in auditing, "If it’s not documented, it’s not done." Proper documentation, compliance with bookkeeping standards, and strategic tax planning are crucial for legally reducing tax liabilities while running a business.
For further assistance with business financial planning, please feel free to schedule a consultation.
Disclosure:
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.