Is the IRS coming for your home business?
In order to claim home business deductions, you must actually be running a business from your home. This seems obvious. However, the IRS tends to target home businesses and then try to classify them as hobbies in order to rob them of the available business deductions. Because hobbies are ordinarily carried out at home, home ventures are especially vulnerable to being classified as a hobby. Thus, it is important to prove to the IRS that you are a legitimate business.
Proving that you are a business
For tax purposes a business is an activity regularly and continuously conducted primarily to earn profit. This does not mean you have to show a profit to be considered a business, but your primary purpose must be to make money. You can do this from home, full-time, or part-time, as long as it is regular and continuous. But, if your primary purpose is something besides making money, you will not be considered a business. So if you carve a hundred pinewood derby cars per year because you love doing it, but you only sell a handful of them and don’t make any money off of it, this would not be an activity primarily engaged in for profit. There are two tests the IRS uses to determine if your activity is a hobby or a business: the profit test and the behavior test.
If your venture earns a profit in three of five consecutive years the IRS will presume you have a profit motive for tax purposes. The IRS will look at your tax return to determine this and any legitimate profit will count. Even if you meet this test the IRS can still try to have your venture declared a hobby, but it will have to prove that you did not have a profit motive. In practice, the IRS generally does not attack ventures that meet this test unless it appears that the numbers have been manipulated.
In this test the IRS will look to see if your venture is primarily for profit making purposes. They do this by seeing whether you behave as though you want to make money. It can be difficult to pass this test if your activity is something like painting or writing, because these activities are often done for fun. However, don’t panic. Painters and writers can still succeed. The IRS looks at a series of factors to see if you behave as a business, with the three below holding the most weight. The top three factors are:
- Whether you act like a business: do you keep good books and good records and carry on your activities in a professional manner.
- Your expertise: people who want to make profits are usually skilled in their field or endeavor
- Your track record: having a track record of success in other businesses helps show you are trying to make money in your recent venture
Remember, however, the IRS looks at other factors and takes a holistic approach to whether or not you are behaving like a business.
If you are running a home business, the IRS may target you and try to classify your business as a hobby in order to shut down your business deductions. However, the IRS uses two tests that you can pass if you structure your business correctly; the profit test and the behavior test. Know these tests well so that you can structure your business to beat the IRS if they ever come knocking on the door of your home. For further expertise, contact a local business attorney.
 Stephen Fishman, Home Business Tax Deductions: Keep What You Earn, 23-31 (Diana Fitzpatrick ed., Nolo 7th ed. 2011).