With the advent of user-friendly web-design applications and nearly endless online marketplaces, it’s easier than ever to earn money online. Freelance writers and graphic designers attract customers by showcasing their portfolios. Multiple sites cater to the so-called gig economy, where members sign up to do odd jobs for a fee. Many people sell handmade items on Etsy, or resell garage-sale finds via eBay.
The benefits of starting an online business can be two-fold. You have the potential to make money and take advantage of business tax deductions just like traditional companies. However, it takes more than a slick website to make you an online entrepreneur. In order to claim many business deductions from the IRS, you must be operating with the aim of making a profit. Tweet This
What is a Business?
Tax authorities rely upon Section 183 of the Internal Revenue Code when considering whether or not you’re running a business for financial gain. Nine specific factors can guide their thinking:
1. How you carry out the activity.
Have you organized your efforts in a way traditionally associated with a business? This could include opening a separate business bank account, keeping thorough financial records, and preparing a realistic business plan.
2. Your level of expertise.
Do you have extensive knowledge about the activity in question? If not, are you seeking advice from experts, mentors, or coaches? If the answer to both is no, the IRS could doubt the sincerity of your efforts to generate a profit.
3. Your time and effort.
The IRS assumes that, in most cases, serious business people will devote substantial time to their company. Time requirements can vary by occupation, so there’s no hard-and-fast rule that a taxpayer must engage in X number of hours to qualify. However, an inconsistent or light schedule might convince a tax examiner to view your activity as a hobby rather than a business.
4. You expect assets to appreciate.
If part of your business plan is to collect assets that will appreciate in value, or if you own an asset that is expected to become more valuable, you may be able to make a stronger case that you’re pursuing profits.
5. Your past success in other business activities.
Even if your new effort is currently unprofitable, a record of past business successes could work in your favor. The IRS may be more likely to believe you’re a business owner if you’ve owned a profitable company in the past.
6. Your history of income or losses from the activity.
Past profits can go a long way in demonstrating that you’re trying to make money off of an activity. Conversely, several years of losses may lead the government to decide you aren’t running an online business at all.
7. The relative amount of profits vs. losses over time.
Reviewing the value of profits versus the cost of losses over time can help the IRS judge how seriously you’re pursuing profitability. Limited profits one year may not be enough to satisfy their concerns if you’ve consistently lost money over the long haul.
8. Your financial status.
If you primarily rely upon income from another source, your online activities may be viewed as a hobby instead. On the other hand, if you’re dependent on income generated from the activity in question, you may have a strong case for running an online business.
9. You have personal motives.
If there is a strong recreational angle to your activity, such as designing model airplanes, you might have a hobby rather than a business. Of course, if you sell a significant amount of airplanes throughout the year, you may be able to demonstrate a profit motive. Note that this factor isn’t based on how much you enjoy your work, but rather the concern that personal enjoyment is a higher priority than profitability.
It’s okay to come up short on some of the tests above. Judgements are often made by weighing multiple factors against one another.
There’s Hope for Hobbies
Many people who think they’re running a business may actually be engaged in a hobby. If your endeavor produces limited income but is not pursued for the purpose of making a profit, tax authorities may judge your deductions according to the so-called “hobby loss rule.”
These guidelines are also spelled out in Section 183. To greatly simplify a complex document, deductible losses cannot exceed the income generated by the hobby or activity. For example, a skilled woodworker who sells $1,000 worth of furniture in one year could not legitimately claim $2,500 in losses. A tax professional can help you determine if you’re engaged in a hobby or are running an online business.
Photo Credit: nazmanm, Twenty20