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When getting into business you must distinguish between a legitimate business and an activity that is considered a hobby or a business that is not at all profitable. The IRS has been targeting hobby losses for many years. Losses from hobbies cannot be written off against other income. Look at it from the IRS point of view. If you love breeding horses, and make no money at it, why should you get a write off? If your new business makes a profit, then you don’t have to worry about the hobby loss rules. On the other hand, if the new enterprise consistently generates losses (deductions exceed income), the IRS may step in and say it’s a hobby rather than a business.

There are two ways to avoid the hobby loss rules. The first way is to show a profit in at least three out of five consecutive years (two out of seven years for breeding, training, showing, or racing horses). The second way is to run the venture in such a way as to show that you intend to make it profitable. The IRS regulations say the hobby loss rules won’t apply if the facts and circumstances show that you have a profit-making objective.

How can you prove that your objective is to make a profit? As a start, you can do so by running the new venture in a businesslike manner. More specifically, the IRS and the courts will

look to the following factors:

• how you run the activity.

• your expertise in the area (and your adviser’s expertise).

• the time and effort you expend in the enterprise.

• whether there’s an expectation that the assets used in the activity will rise in value.

• your success in carrying on other similar or dissimilar activities.

• your history of income or loss in the activity.

• the amount of occasional profits (if any) that are earned.

• your financial status; and whether the activity involves elements of personal pleasure or recreation.

The classic “hobby loss” situation involves a successful business person or professional who starts something like a horse ranch or a farm. But the IRS’s long arm also can reach out to more common situations, such as business people that start what appears to be a bone fide sideline business. Before starting your business speak to your CPA to make sure it is considered a legitimate business in the eyes of the IRS. While hobbies can be a source of relaxation and satisfaction we don’t want the IRS to deem your business that you work hard in to make successful a mere hobby. And as you are starting to realize right at the start you may need the help of...