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How doing what you love may land you in hot water with the IRS

Everyone has personal interests and in some cases, an individual may be lucky enough to turn a passion or interest into a full-time job. From photography and pottery making to breeding dogs or horses, some industrious entrepreneurs are determined to turn their hobbies and pastimes into profitable ventures. 

For anyone who plans to profit from selling goods or performing services, it's important to understand the possible tax-related rules, requirements and implications. For those hoping to make money doing what they love, it's especially important to understand the IRS' stance when it comes to distinguishing between an actual business and a hobby. 

While entrepreneurs and small business owners who experience profit losses are allowed to deduct such losses to "offset other income, including wages, interest and dividends;" the same isn't true if economic losses are related to a hobby.  

In cases where an individual earns income via a hobby, the income is taxable and any related expenses can only be accounted for under the section "Miscellaneous Itemized Deduction" on a Schedule A and the deducted amount must exceed the standard deduction. 

Why the distinction? Basically the IRS isn't in the practice of paying people to enjoy their hobbies. What's more, a recent audit conducted by the Treasury Inspector General for Tax Administration determined that, for 2013 alone, taxpayers wrote off hobby-related expenses to avoid paying more than $70 million in taxes.

Of course even legitimate businesses may experience financial struggles early on. However, in cases where a business reports losses for "three or more out of five consecutive years," the IRS may grow suspicious. So how do legitimate business owners justify a venture's lack of profitability? 

To prove that a business is indeed a business and not simply a hobby, business owners are advised to take steps to formalize a business plan, keep business and personal assets separate and maintain accurate financial records. 

Source: Forbes, "Watch Out, Hobbyist Tax Cheats: The IRS Is On To You," Janet Barry-Johnson, May 4, 2016

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