The IRS often tries to eliminate the tax benefits
of a sideline activity by arguing that it is a hobby,
not a business. If the IRS declares your sideline
business a hobby, you can't deduct any more than you
make on the hobby.
In effect, then, your sideline business income can
be tax-free, but you will not be able to deduct non-
cash expenses such as depreciation. And you won't be
able to use the business to lower your family's overall
taxable income.
There are several ways to avoid having a sideline
business treated as a hobby. The tax code provides a
"safe harbor" rule. If you profit from a sideline
three out of any five consecutive years, you're safe.
(If you breed horses, the safe harbor rule is three
profitable years out of any seven consecutive years.)
Taxpayers who don't qualify for the safe harbor
rule still have hope. You have to make a case for the
fact that you are trying to be profitable. Some
documentation that will help is proof of advertising,
promotion, proposals, market research, and the like.
Save your rejection letters.
Two recent court cases established pro-taxpayer
decisions on this issue. In each case, the taxpayer
never made a profit, but the sideline still qualified
as a business. According to the courts, the most
important factor is that you conduct your sideline
business in a professional manner. If you take it
seriously, the courts may take it seriously.
Find out what either the industry or the local
norm is for all your business procedures. Follow the
norm unless you have a more effective way of doing
things. And always keep complete records.
