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Did you report a tax loss last year from an activity that you believed to be a valid business activity?Losses from activities conducted as "for-profit" businesses are allowed for income tax purposes. These losses can offset other income from wages, interest, dividends, etc. Losses from an activity that isn't conducted for-profit, known as hobby losses, aren't deductible against other income.

This month’s tax tip will help you determine the tax status of losses incurred from your activities. Besides considering whether the activity generated a profit, you also need to know how the IRS applies the "facts and circumstances" test to determine the for-profit status of your activity. If your activity is in danger of qualifying as a hobby, it is very important to take the necessary steps to transform your hobby into a "for-profit" business.

In general, your activity automatically qualifies as "for profit" if its gross income exceeds its deductions for at least two out of five consecutive years. However, failing to meet this net income requirement doesn't automatically deem the activity a hobby. You can still prove that the business is conducted for-profit and thereby deduct losses if you pass the "facts and circumstances" test.

The following factors have been used regularly by the IRS in determining whether an activity is carried on for profit:

• Manner in which you carry on the activity.
• Expertise of you and/or your advisors.
• Time and effort personally spent on the activity.
• Expectation that assets used in the business willappreciate in value.
• Your success in carrying on other business activities.
• Your history of income or loss with respect to the activity.
• Your financial status.
• Elements of personal pleasure or recreation.
• Amount of occasional profits, if any.

While these are the major areas considered in the "facts and circumstances" test, they aren't the only factors involved in the profit or hobby determination. Also, the activity's status isn't always determined by satisfying a simple majority of the above indicators. The side supported by five or more of the above factors doesn't always determine the outcome of the argument. Your activity could theoretically show a for-profit motive under eight of the above nine tests, but the ninth factor could so overwhelmingly indicate a hobby that the activity would be categorized as a hobby. On the other hand, a strong hint of a for-profit motive in one of the above tests could override the fact that the other eight tests imply hobby. This test is called "the facts and circumstances test" because the facts and circumstances surrounding each specific case are unique and must be scrutinized carefully before determining whether the activity is for profit or a hobby.

There are actions you can take that will help to convey a for-profit motive. These include implementing structured bookkeeping by keeping thorough and business-like books; using a separate business checking account and business credit card; recording business and personal use of assets in a log-book; Operating like a professional by obtaining the proper license, insurance, registration, certification, etc. needed for that type of business; maintaining a qualified home office and a second telephone listing strictly for the business; looking to the future by making periodic changes in business operations to increase profit potential; and researching current market trends and technology used in similar businesses.

If you are uncertain about the status of your particular activity, I would be happy to discuss it with you and, if necessary, make appropriate recommendations.

 



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